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60-Second Guide To Index Trackers

By James Carlisle
August 12, 2002

By investing in an index tracker, you can beat the pants off the vast majority of managed funds, simply by investing in the UK's biggest blue-chip companies. It's shockingly easy and, in the next 60 seconds, we'll show you how to do it.

0:58 What is an index tracker?
An index is a just a collection of shares designed to reflect the overall performance of some part of, or more likely the whole of, a particular stock market. The main indices in the UK are the 'FTSE 100' and the 'FTSE All Share' and they're designed to reflect the overall performance of the London stock market. Index trackers invest in the shares included in a particular index, so their performance tracks the performance of that chosen index.

0:49 Why invest in an index tracker?
What's so great about just tracking the performance of a particular index? Well most professional fund managers find it hard to do! In fact, only about 1 in 5 of them has managed to beat the FTSE All Share over the last 20 years (and that's just of the successful ones that are still around!). The problem they have is that they tend to charge a lot more. So they're handicapped by more money dripping out of the fund each year (and into the fund manager's pocket), leaving less to go into your investments. Few of the professionals are good enough, or lucky enough, to overcome this handicap and it's next to impossible to spot them before the race, as it were.

By investing in an index tracker, you also avoid the risks of doing very differently from index. OK, so it means you don't give yourself the chance of picking the 1 fund in 5 that might do better than the index, but you'll also avoid picking the 4 funds out of 5 that might do quite a bit worse.

0:36 Which Index?

There are lots of different indices around, so which to go for depends on what you're trying to do. Most people just want to reflect the overall market average and, to do that, you need a 'broadly-based' and 'weighted' index. 'Broadly-based' just means 'lots of different shares from all across the market'. 'Weighted' means that the index, and therefore the index trackers, include the shares in proportion to their overall size (ie the total amount of money that's invested in them by everyone in the market). This means that your index tracker will stay in line with the market average.

The 'broadly-based and 'weighted' indices in the UK are the 'FTSE 100' and the 'FTSE All Share'. The FTSE 100 is made up of the 100 biggest companies on the market and these, between them, make up about 80% of the market's value. So we're already pretty 'broadly-based'. If that's not enough for you, then there's the FTSE All Share which, although it doesn't actually include all the shares on the stock market, does include about 700 of them, accounting for about 98% of the stock market's value.

Between the FTSE100 and the FTSE All Share it probably makes very little difference which you go for, but there's more about choosing between these and other indices here.

0:24 What type of fund?
There are three main types of fund in the UK, unit trusts, investment trusts and exchange traded funds. The different types of fund have their own pros and cons,  but the key is to find the cheapest means of doing what you're aiming to do. Generally speaking, unit trusts will be most suited to regular monthly investments, while investment trusts are best suited to lump sums. Exchange traded funds, or 'iShares' in the UK, might work well if you want to do a bit of both. Whatever the type of fund you go for, you stand to save on some tax if you invest through an individual savings account.

0:17 Charges & tracking error

The cheaper tracker is nearly always the better tracker. Many UK trackers have annual charges of less than 0.5% a year. If you want track a slightly more exotic index, like an index of US or European shares, you may have to pay a little bit more.

It's worth checking to see how closely a fund has tracked your chosen index in the past. Tracker funds attempt to mimic the performance of an index but it's unlikely they'll be able to perfectly match it as they have to physically buy and sell the shares concerned. The difference between the performance of the index and that of the tracker fund is called the tracking error. Obviously you want this to smaller rather than larger. Although it is possible to work the tracking error out for yourself it's usually a lot easier to ask the individual company concerned and compare this against the others on your shortlist.

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