Tracker Funds - Overview

Did Neil Woodford do more for trackers than any advertising ever could?

Is it possible that your best investment is passive tracker fund?

Yes, the more you look at managed funds the more that you see that the bad years outweigh the good ones and sometimes the losses are very significant.

Summary

Many people quite reasonably decide that actively managing their investments is too complex for them and wish to delegate this task to the experts.

The wise then try and become informed and very often end up concluding that the best solution for them is a tracker, a passively managed fund that just buys the shares that make up an index such as the FTSE 100.

This sounds unambitious and boring and surely an expert buying and selling only certain shares will do better?

The trouble is that the answer will generally be no, it is sort of beyond belief that there is this massive financial services industry but the best thing to do is almost nothing.

A great example of this can be seen if you type "Buffett and Protege bet" into a search engine.

The basic argument is that you can always find a fund manager doing really well, but over a longer period and all investments actively managed funds nearly always fail to outperform the market as a whole.



Tracker Funds - The "But"

The big, big but that advocates of "put your money into a FTSE 100 tracker" ignore is that they look solely at percentages and are unconcerned by the amount of money that represents.

The sales pitch goes along the lines of "Mrs Bloggs bought a tracker 20 years ago and she is living off the dividends and her fund is growing faster than inflation."

Oh by the way Mrs Bloggs started her tracker fund off with just £2 million!

If you are starting of with say £10,000 you will be getting the same percentage growth as Mrs Bloggs, but her 10% is £200,000 and your 10% is £1,000.

Does it even need saying that most people wouldn't spend £200,000 a year but couldn't live on £1,000?

Of course what your needs are, are irrelevant if the market cannot generate them and if it can then why are the people who run the trackers not doing this "thing"?


Tracker Funds - How Is The Money Spent?

A tracker fund will normally buy all the shares in an index, but it will not simply say there are 100 companies in the FTSE 100 index and you have £100 so it will invest £1 in each company.

Instead it might say company 1 is worth twice company 2 so the tracker will by twice as many shares in company 1.

If you had a FTSE 100 tracker this would mean that roughly half of your money would be invested in about 12 companies (May 2019), the other half in the remaining 88 companies.

This weighting brings some undesirable side effects, such as the biggest companies tend to be in a few market sectors, Oil and Pharmaceuticals.

So if you imagined that your tracker gave you a diverse portfolio of 100 companies the reality could be 20% in oil and 20% in drugs.

Recognising this risk there are the so called "Smart Trackers" that use various strategies to remove market sector and company size weighting.

Once you do this it is no longer just a tracker and the weighting may result in significantly better or worse performance than a simple tracker.


Tracker Funds - The Costs

Trackers tend to be low cost as they can be operated automatically and the market for them is reasonably competitive.

The only issue is that it can be difficult in practical terms to work out what these fees will be as there are different way of presenting them, but generally expect them to be in the range of 0.2% to 1%.

Note in big bold letters that this is 1% of the investment not 1% of the profit.

If you are fortunate enough to have a significant investment then it is worth checking if there is an upper limit on fees, such as the fees will never be more than £200 per year.

Whilst the fee doesn't sound much, it is payable each year regardless of a growth or losses in the fund value, so in a year with minimal or no share price growth a 1% fee could easily be 25% of the dividend income.

It is inherent in a tracker that it must occasionally buy and sell shares, these transactions will incur dealing fees and stamp duty. Usually these fees are absorbed by the fund meaning that the tracker will always grow slow slower than the index it is tracking.


Tracker Funds - Risks

Although the FTSE 100 tends to go up over the long term there are periods with little or negative growth.

Even during periods of little growth or losses;
  • You will still be paying your management fees

  • Companies will be leaving and joining the index meaning that shares will have to be sold, potentially at a loss and bought possibly at a premium to their true value.

In a rising market the operating costs are relatively easily absorbed, in a stagnant or falling market fund management and trading costs and losses can start a serious decline in a funds value even if the index remains at a fairly constant value.


Tracker Funds - Some Real World Numbers

Period 1 - The FTSE 100 started the year 2000 at around 6,100 and on the 18th April 2019 is at 7,437, this is a growth of 21% over 19 years.

Period 2 - The FTSE 100 on the 6th April 1984 was at 1,096 and at year 2000 was around 6,100, this is a growth of 450% over 14 years.

During period 1 you would have lost out heavily to inflation in terms of your capital, most of your dividends would be needed to offset this loss.

Period 2 is much nicer, but is it repeatable?

So again we see what was highlighted and repeated in the short term holding section, what works for an institutional investor who has a long term view may be problematic for a private investor with a fixed date for retirement and needing the results of a successful investment.


Tracker Funds - Professionally Administered

Like most things in financial services not all is as it seems.

A tracker is a tracker is a tracker, surely they must all be the same?

Summary
The point of a tracker is to use a very simple rule, buy companies within an index and do nothing with them until they leave and then sell them.

At first glance this sounds so simple that it is obvious that a professionally managed tracker is the way to go, but there is a catch in that not all trackers actually do what you may think they are doing.


Tracker Funds - Is it Doing What You Think It Is?

At first glance you may think that if you go and get a tracker fund then that fund will rise and fall by the exactly the same amount as the underlying market, but this is rarely the case.

The main reason for not exactly tracking the underlying index is cost, in the UK the tracker has to pay the same 0.5% stamp duty on share purchases that you do.

While you normally you don't get a bill for this as the cost is taken out of the value of the fund as a whole you are still effectively paying it.

This cost can affect the accuracy of the fund in mimicking the market in a number of ways.
  • It is not unknown for trackers to only purchase a portion of the shares in the index, possibly leaving out the smaller companies or ones likely to be dropped from the index.

  • The tracker doesn't update its portfolio when a share's portion of an index changes significantly.

  • The tracker doesn't update its portfolio immediately when shares join/leave an index.


But I Don't Want Shares In XYZ

If you look at any index you will see companies whose shares you may not like.

They are in a market that you think is dying, they have too much debt, "Everyone knows that Mr SomeoneOrOther is a bit of a chancer" etc.

With a tracker you have to buy shares in that company.

The purpose of a tracker though is to remove your rational/irrational dislikes and company XYZ may be the most successful company in the index.

I saw this argument recently and in the same article it mentioned that buying BooHoo in Jan 2015 would have shown a 10 times return, much more than any tracker and that is why the author avoids trackers.

This ignores the fact that Boohoo launched on The AIM in 2014 at 50p and dropped as low as 22p the time to buy to get this magic return.

It seems a bit weird to me to compare major company trackers and an AIM share as they have such different risk profiles.


Professionally Administered - Any Other Choice?

Even if you were to pick the FTSE 100 to track you would need at least £50,000 to be able to buy the shares personally without fees and stamp duty having too great an effect on profitability.

This simple fact means that most people who want to track an index have to buy into a fund.

Even if you could afford to buy the 250 companies shares in the FTSE 250 would you really have the time and inclination to manage it?

It is also probable that a professionally run fund will actually be cheaper than doing it yourself as when a share need to be bought or sold stamp duty will be the same for a fund and private investor but the fund may very well have lower dealing fees.


Tracker Funds - Self Administered

If trackers are that simple do I even need to pay for a managed one?

A lot depends on how much you have to invest and how much you value your time?

It's probably true that if you have enough that a self managed tracker makes sense then you would rather spend your time having fun.

Summary

On the Previous page we saw that it is quite possible that the tracker that you bought doesn't actually track in the way that you wanted.

Because of this creating and running your own tracker may appear attractive despite the time and costs needed to set it up and maintain it.



Self Administered - Is It Even Viable?

I would expect that nearly all private investors simply don't have enough money to buy a reasonable quantity of all the shares needed to run a viable tracker.

If you had £50,000 and decided to track the FTSE 100 that would be £500 worth of shares per company. Buying each company would incur dealing fees of around £10 per company (100 * £10 = £1,000) which is 2% of the investment and another 0.5% for stamp duty gives a total of £1,250 in costs.

If you were using a different investment strategy you would probably spend this £50,000 over say 10 companies which would incur dealing fees of around £10 per company (10 * £10 = £100) which is 0.2% of the investment, stamp duty is another 0.5 giving £350 in total.

The difference doesn't seem that great but being blasé about the odd thousand here and the odd thousand there is likely to lead to losses not gains.

Given all the work involved and fees incurred I am left thinking that the only reason to run your own tracker is that you want to track something that there is no product for.

This could be something recognised such as the FTSE AIM 100, the top 100 companies on the Alternative Investment Market or an index that you have created yourself.


Pseudo Trackers?

At first glance it may seem tempting to invent an index and track that, for example the top 20 shares in the FTSE 100 and FTSE 250.

Although this sounds attractive there is no readily available information to say that this makes any sense at all. So you would need to do a lot of research to see if the basis for your index has any merit.

In practice this example would mean buying companies on the way down as they fall out of the FTSE 100 and become big players in the FTSE 250 and selling companies on the way up as they are promoted from the top of the FTSE 250 to the bottom of the FTSE 100.

Another idea might be companies in the FTSE 100 with a low debt to earnings ratio, this sounds sensible, I like the security of the FTSE 100 but don't like XYZ as they have too much debt.

The trouble is that XYZ may be a big dividend payer, just moved into the FTSE 100 and are on the way up and most of their debt has been incurred buying their own premises so it can be argued that they don't really have any debt at all!


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