Why do-it-yourself index trackers don't work.
The other day, I wrote an article advocating the use of index trackers and index tracking ETFs as a type of defensive share.
The logic? Given the practical difficulties of picking individual defensive shares, index trackers at least hold out the promise that you won't -- costs and tracking error apart -- do any worse than the index in question.
But a reader's comment made a point that I've seen made several times before.
And it's this. Why buy the FTSE via an index tracker, when you can cut out the middleman and buy the individual shares?
In theory, it's a great idea. And it's certainly a point I've made myself, in respect of a few high-profile (and high-cost) investment funds that are little more than closet trackers.
With a lot of their investors' money parked in a dozen large FTSE 100 shares, these funds charge eye-watering fees. And, make no mistake, they're certainly an instance where investors could genuinely cut out the middleman, and buy the same dozen shares themselves.
But that's a very different proposition from a do-it-yourself index tracker.
£10,000 to invest
Let's say that you want to hold £10,000 in your very own do-it-yourself index tracker.
Even at the upper end of the FTSE 100, the idea quickly breaks down. On today's prices, for instance, you'd invest just £678.15 in the FTSE 100's largest share, HSBC (LSE: HSBA), which makes up 6.78% of London's flagship index.
Similarly, you'd buy £611.60 of the next-highest ranked share, Vodafone (LSE: VOD); and then spend £524.79 acquiring a stake in oil giant Shell (LSE: RDSB).
After that, it starts to get a bit silly. By the time you've built stakes in the FTSE 100's ten largest shares, you're plunking down £286.45 for the privilege of owning a piece of AstraZeneca (LSE: AZN), for instance.
These aren't big stakes by any means. And each one is incurring you brokerage fees and stamp duty. In short, costs quickly start to mount up.
And down at the bottom end of the FTSE 100, your broker's fee and stamp duty are likely dwarfing the size of the stake you're buying. £4.96 of Schroder's (LSE: SDRC), anyone? £6.96 of Essar Energy (LSE: ESSR)? Or £8.59 of Hargreaves Lansdown (LSE: HL)? No, that's just stupid.
£100,000 to invest
But surely, then, the principle of the do-it-yourself index tracker works with a bigger investment pot? Such as £100,000?
Not really. Down at the bottom end of the FTSE 100, it turns out that you're still buying stakes of less than £100.
Even in the middle of the FTSE 100, you're spending less than £400 to buy into business like Kingfisher (LSE: KGF), Smith & Nephew (LSE: SN) and International Power (LSE: IPR).
Only in the FTSE's top ten shares are your investments coming to more than £4,000 each.
Restrict yourself to that subset of shares, and spend your entire £100,000 on just those shares, and you'll certainly cut your investment costs. Just ten lots of commission, in short, and ten lots of stamp duty to pay.
On the other hand, you'll have embraced just 46% of the FTSE 100, leaving you massively exposed to tracking error. And also leaving you with an investment pot that contains six oil and mining shares -- plus a bank, a telco, a tobacco business and a pharmaceutical firm.
Balanced and diversified? Not exactly.
And a not dissimilar picture emerges if you expand the investment universe to the top 20 shares. Your average stake drops to £3,366 or so, and a few consumer shares such as Tesco (LSE: TSCO), Diageo (LSE: DGE) and Reckitt Benckiser (LSE: RB) come into the frame. On the plus side, though, you've captured 67% of the FTSE 100.
Buy a tracker, not an index
All of which tends to make low‑cost index tracking funds from providers such as Vanguard, HSBC or Fidelity look remarkably good value. Vanguard, let's remind ourselves, has a TER of just 0.15%, with HSBC coming in at 0.27% and Fidelity at 0.3%.
Or, in the shape of individual shares that you can tuck in your portfolio, index‑tracking ETFs such as the HSBC FTSE 100 ETF (LSE: HUKX), or iShares' FTSE 100 ETF (LSE: ISF). HSBC's ETF costs you just 0.34%, while the iShares product is a tad more expensive at 0.4%.
Try beating those charges with a do-it-yourself index tracker.
Looking for other index-tracking investment ideas? My colleague Padraig O'Hannelly's round-up of the cheapest trackers admittedly pre-dates the arrival of low-cost specialist Vanguard -- and HSBC consequently slashing its charges in response -- but is otherwise spot on. Happy hunting!
More on the markets:
> Both Malcolm and The Motley Fool own shares in AstraZeneca, Tesco, and Reckitt Benckiser. Malcolm also holds index trackers with Vanguard and HSBC.
> Worried about the state of the markets right now? Then get the Fool's latest free guide - What To Do When The Market Plunges