Index fund

What are index funds and how do you invest in them?

Index funds, also known as “tracker” funds, are a type of passive fund that invest in a basket of shares (or use derivatives – known as “synthetic replication”) to mirror the performance of an underlying index.

So for example, a FTSE 100 index fund would simply copy the composition of the FTSE 100 index, with the goal of delivering the same annual return (at least, before costs are deducted).

Index funds don’t employ professional managers to decide what stocks to buy, and so carry relatively low fees. The fund will always underperform the market slightly after costs, but you can be pretty confident it will otherwise be able to track the market relatively closely.

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Active funds by contrast charge higher fees and employ stock picking fund managers in the hope that they will beat the market, thereby justifying their higher costs. Unfortunately, over the long run, only a minority of active fund managers manage to beat the market consistently, which is one reason why index funds (and other passive funds) have become increasingly popular over the last few decades.

In practice – and as Jack Bogle, the “father” of passive investing and founder of asset management giant Vanguard demonstrated on several occasions – it's an arithmetical inevitability that both active and passive funds will collectively underperform the market. After all, for every winner in a trade there's a loser. So in the end, the average investor gets the market return, less costs.

What should you look for in an index fund?

One key aim is to have as low a tracking error as possible. The tracking error is the difference between the performance of the underlying index and the fund. So a tracker that returned 5%, when the market only went up by 4%, would raise serious questions, even although it beat the market – because it’s not supposed to do that.

The other key factor is cost. As mentioned above, one of the main advantages of index funds generally is that they are very cheap compared to active funds. But competition between passive providers is intense, so it’s worth shopping around. On the biggest indices – such as the S&P 500 and the FTSE indices – costs are in many cases negligible, as a brief look down lists of the low-cost index funds will show you

How do you buy index funds?

Index or tracker funds can be bought via any fund platform or broker. They might be open-ended funds (Oeics) or stock-exchange listed funds (exchange-traded funds, or ETFs). When considering which type of index fund to buy, one point to consider any differences in how your broker might charge for listed funds versus open-ended ones, both in terms of buying and holding.

What is a “closet” tracker fund?

The reason investors still put money into active funds is that they hope they'll pick one of the winners, rather than one of the many losers. The trouble is, to beat the market convincingly you need to take risks – perhaps by taking large positions in a small number of stocks. The danger then is that you might underperform the market badly, even if only in the short run.

This “career risk” has in the past led to some active managers picking portfolios that differ little to the overall market in order to make sure they don’t underperform. These funds are "closet trackers" and represent the worst of both worlds: they charge high active fees, but deliver a passive return.

The practice is increasingly frowned upon by regulators. But it’s worth being aware that there are ways to spot a closet tracker. An obvious method is to look at its past performance and how much it differs from the wider market.

Another metric to look at is the “active share”. This compares how significantly a fund's portfolio differs from its benchmark index. The higher the score, the better. In effect, investors in a closet tracker which “hugs” its index are being ripped off – they are being charged the high fees that go alongside active management in exchange for nothing more than passive performance.