Index funds (also known as passive funds or “trackers”) aim to track the performance of a particular index, such as the FTSE 100 or S&P 500. The funds may hold all or a representative sample of the stocks in the underlying index (“physical replication”, or replicate the performance of the index via buying derivatives (“synthetic replication”).
The aim is to have as low a tracking error (the difference between the performance of the index and the fund) as possible. So a tracker that returned 5%, when the market only went up by 4%, would raise serious questions, even though it beat the market.
The first tracker open to ordinary investors was the Vanguard Index fund, which launched in 1975. Rivals were sceptical as to whether it would ever succeed, arguing that people wouldn’t be satisfied with merely average performance, but the concept has caught on (particularly as active managers often fail to beat the market).
A big advantage of passive investing is cost – for example, the BlackRock 100 UK Equity Fund, which tracks the FTSE 100, charges just 0.07% a year. A typical active fund could easily charge ten times as much, and often significantly more.
A “closet tracker” is an actively managed fund that “hugs” the underlying index in order to avoid underperforming the market too drastically (thus losing clients). This is a subjevt of increasing controversy in the financial industry, with regulators across Europe looking into the issue. In effect, investors in a closet tracker are being charged the high fees of active management in exchange for passive performance