Hello everyone! You’ll see both here and on various investing blogs about the concept of an index fund and a tracker fund. As a result I thought I’d write a post detailing what these are and how they work.
What is an Index Fund?
Index Funds are so called because they came out of linkage to the concept of a stock market index – used as a proxy barometer for stock market health. You’ll have seen this in the form of the S&P 500, FTSE 100 or the NASDAQ to name a few.
Let’s take the FTSE 100, the main index in the UK – comprised of 100 of the largest companies in the UK.
An index fund is simply a construct where instead of buying an individual stocks, you buy a unit in the fund where thus unit is the equivalent of owning an small piece of stock in all FTSE 100 companies, weighted in line with how much of the market those companies make up.
In this example, the next effect would be that your rate of return on the investment should extremely closely track the performance of the FTSE 100 itself.
Whilst I’ve used the FTSE 100 as an example to illustrate the point – you can buy a fund replicating just about any index, such as the NASDAQ or S&P 500.
Another route is to target a particular section of the market, which we’re covering in greater detail in our notes on tracker funds below.
Usually, both index and tracker funds are managed through a structure called an ETF (Exchange Traded Fund) – an innovation developed as investment technology evolved which significantly reduced the cost and increased the mass appeal of this type of investing.
(Technical note: There can be small differences in return vs. the underlying index in practice owing to the practical element of ensuring your position in all 100 stocks is equal. This is known as tracking error, and a good index fund will seek to minimize this as much as possible).
As ever – our normal note that we take care with what we write on this site but it is not official “financial advice” and you need to consider if any financial product is right for your circumstances. We always advocate doing your own research. If you’re in doubt about anything, it’s worth consulting a regulated and reputable financial advisor who can provide tailored advice built for you.
What is the difference between an Index Fund and a Tracker Fund?
Conceptually, they’re the same thing and often the terms are used fairly interchangeably in practice. To my mind the difference is that an index fund will especially track an index and a Tracker Fund is more commonly following a sector or targeted strategy.
For instance, a Technology tracker fund is likely to identify a benchmark which tracks the prices of the largest Technology companies within the US, and so target a strategy of building around this.
If you have a belief that a particular sector or geography is doing to do particularly well within the market, you might therefore invest in one of these funds.
What are the advantages of investing in an Index Fund or Tracker Fund?
Index Funds and Tracker Funds offer Diversification Benefits
We speak frequently here at the Wilderness about the benefits of diversification.
If you invest in an index fund or tracker fund, you get exposure to many different business models rather than just the single stock exposure you’d get from investing in a single company.
This is important, as it can help limit volatility and manage risk – even a good company can get hit by an unexpected shock or wider market events. By not putting our eggs in one basket, we limit the exposure to these risks we can’t control.
Note that if you are investing in a tracker fund that focuses on a sector or geography, these investments are more likely to be correlated – you’ll get more diversification benefit than if you’d invested in a single stock, but not as much as if you’d invested more widely.
Remember that you can split your investments between multiple index funds / tracker funds to help manage this.
Index Funds and Tracker Funds are a cheap way to invest
Buying 100 investments individually could potentially end up racking up quite a lot in dealing or brokerage fees. However if you invest via an index fund or tracker fund the mechanics of this have become extremely cheap to do.
An example of this is Vanguard’s FTSE 100 ETF, which has an ongoing charge of just 0.06% of your investment per year – that’s incredibly cheap by historic investment standards!
There’s a couple of factors behind this:
- Index and Tracker funds are often managed by algorithms and computers as the investment decisions become fairly simple. Without a (usually expensive) human making the investment decisions, the process becomes a lot cheaper to run.
- Investing in individual stocks often attracts charges
Index Funds and Tracker Funds can help you avoid investment bias
If you don’t have time to research individual companies in depth, it’s very easy to end up trapped in a category of investment bias because you’re drawn to familiar or household company names because you’re familiar with them or their business model – but this doesn’t always equate to a good investment.
A tracker fund can help you get invested into some of those dare I say it, slightly more boring companies that actually do a great job of providing good investment returns.
Index and Tracker Funds can be found for your personal risk profile
Index and Tracker Fund ETF’s come in all shapes and sizes, so if you’re looking for something high or low risk you can usually find what you need.
All index funds or tracker funds should have a Key Investor Information Document attached, which should provide clear details on any funds recent return history and overall risk profile. Before investing, it’s well worth taking a look at these and giving them due consideration.
You can invest in Index Funds and Tracker Funds within an ISA structure
Putting your money in a stocks and shares ISA can be really beneficial, as you can invest a fixed amount per year where any gains you make (be they in the form of dividend payouts or capital gains) are exempt from tax where within the ISA.
You can invest in a Index Fund or Tracker fund within an ISA – we’ve written a full guide to the available options around ISA’s right here.
Where can I invest in Index Funds or Tracker Funds?
You’ll find index fund or tracker funds available with any major provider, as they’re a common investment option.
We strongly recommend doing your own research as to which service provider is right for you – whilst they all provide similar services, the specific options and interfaces vary.
Personally I use a combination of Vanguard who have a great list of self constructed low cost options, and InvestEngine who offer a slightly wider range and we’ve reviewed here and think is great for fund beginners.
Can you lose money in index funds or tracker funds?
Yes – like any investment they offer the potential for higher returns but you are taking an element of risk. The specific amount of risk depends on the underlying fund you’ve invested in, and you should be able to get a sense of this from the Key Investor Information Document, so should keep an eye out for this.
We think index and tracker funds offer some great investment options. If you’ve got questions on them, then please do drop us a note in the comments below.