Three Index Tracker Mistakes To Avoid

Published in Investing Strategy on 7 September 2009

Picking a cheap index tracker is not always straightforward.

Index trackers are very rightly popular with smart investors. At a bargain price, they offer a compelling combination of stock market returns and effortless diversification.

And very rightly, too, many investors have become focused on making sure that they are indeed paying that bargain price. Thanks to its insistence on continuing to levy a now-expensive 1% annual charge, for example, Virgin's once market-leading product has been eclipsed by Legal & General's (LSE: LGEN) popular UK Index FTSE All-Share tracker, which has annual management charge of just 0.5%.

And many investors, too, know that they have to look beyond that simple annual charge, and compare providers' Total Expense Ratio (TER) -- the 'all in' cost figure. This, of course, is the figure we tend to use when writing about trackers here on The Motley Fool.

But as investors have got cannier, providers have got wilier. Here are three tracker mistakes that can seriously sap your wealth.

'Bait and switch'

When mighty US fund provider Vanguard at long last entered with UK market with a range of long-awaited low-cost trackers, a shake-up in the charges levied by other providers was widely expected.

HSBC (LSE: HSBA) didn't take long to respond, cutting charges across a range of tracker products. The annual charge on its HSBC FTSE All-Share Index Fund, for instance, was slashed to just 0.25%, equivalent to a TER of 0.27% -- a move that quickly attracted market attention. Start comparing low-cost trackers, and you'll soon spot HSBC's offering, something that would have been unthinkable a year ago.

But walk into your local HSBC branch, and the FTSE All-Share tracker they'll try to sell you is an entirely different animal. For a start, there's a whopping 4% upfront charge. That's right: for every £100 you invest, only £96 gets put to work. Yikes. Plus, on your way out of the door, they drain your life-blood out, and sell your daughters into slavery. (OK, I made that bit up, but you get the idea....)

Buy via HSBC's website, and a 'special offer' reduces this wealth-sapping charge to 'just' 1%. Big deal. And in both cases, there's an annual management charge of 0.5%. Either way, it's a poor proposition, and one that investors shouldn't touch with a bargepole.

To get the real low-cost tracker deal, you'll need to invest via one of the popular fund supermarkets. In the case of the FTSE All-Share index, for example, the fund you're looking for will probably have the all-important word 'institutional' added to the name. But to be sure, check the listed charges first: a good fund supermarket will make the TER abundantly clear.

All TERs aren't equal

In the vast majority of cases, the difference between a tracker's annual management charge and its TER is tiny. As we've just seen, HSBC FTSE All Share tracker's annual charge of 0.25% equates to a TER of 0.27%, while the 0.5% annual fee on Legal & General's UK Index FTSE All-Share tracker works out at a TER of just 0.52%.

Investors, rightly, could be forgiven that a low management charge automatically means a low TER. But they'd be wrong. Fidelity, for instance, trumpets that the annual management charge on its popular Fidelity MoneyBuilder UK Index is a market-leading 0.1% -- and I, for one, certainly haven't found a cheaper offering anywhere else.

But the TER on the Fidelity tracker isn't the 0.12% or thereabouts that might be expected. Instead, it's 0.3%, an altogether less attractive deal. What's more, Fidelity have recently increased it: the TER used to be 0.27%.

The Fidelity product is still a good one, in my view, and the TER of 0.3% still makes it one of the lowest-cost offerings on the market. But it's not quite the deal that Fidelity make it out to be: their marketing literature brags about the low management charge of 0.1%, and you have to dig deeper to discover the TER.

"Firms aren't obliged to disclose their TER," warns Christopher Traulsen, director of fund research at Morningstar. "Look at many of their fact sheets, and you'll see low annual charges, but no mention of the TER." By law, he explains, it must be printed in the 'simplified prospectus' that firms must provide -- but needn't be specified elsewhere.

The Vanguard complication

While Vanguard have been lauded for finally entering the UK market, their arrival has complicated the calculations that investors must perform.

Vanguard's annual charge on its FTSE All-Share tracker is a very attractive 0.15% -- not quite as good a deal as Fidelity's, but still pretty darn cheap. But -- and here's the rub, pay attention -- its TER is also 0.15%, a feat achieved by levying a one-off upfront charge of 0.5%, in order to cover fund costs such as stamp duty.

As common sense -- and Morningstar's Christopher Traulsen -- will tell you, that means that the Vanguard fund isn't for short-term switchers. So if you think that you'll switch out of the Vanguard fund after a few years, offerings such as the HSBC fund are cheaper.

On the other hand, if you're content to leave your money with Vanguard, then the Vanguard deal is the cheapest going -- and hopefully will remain so. Vanguard themselves make the same point on their website, pointing out that their charging structure is designed to reward long-term buy-and-hold investors.

As it turns out, having weighed up the various offerings on the market, I'm about to switch one of my own FTSE All-Share tracker investments into Vanguard's offering.

In order to bypass Vanguard's minimum investment of £100,000 (yikes), I'll be doing so via one of the small-but-growing number of fund supermarkets that offer the Vanguard product -- and I'll hopefully I'll be leaving it there for at least ten years or so.

> Buying and selling shares? Look no further than The Motley Fool Share Dealing service. Trades cost just £10 and it's free to open an account.

> Malcolm Wheatley holds the HSBC FTSE All-Share tracker within his SIPP, while his delightful wife Mandy holds the Legal & General UK Index tracker within her ISA and SIPP.

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sstudent 07 Sep 2009 , 9:51am

With all the problems that banks & other companies have had I've been lathe to move from virgin. I accept that their 1% is higher than some others trcakers but I have always been very happy with their customer service where others I've dealt with have not been that good. So for now it's better the devil I know.

anshah 07 Sep 2009 , 11:52am

Good article.You mention "small but growing number of fund supermarkets offer Vanguard funds", do you know who apart from Alliance Trust offer these?
Also do I understand right that due to the upfront 0.5% charge that Vanguard charge, it doesn't make sense to invest in their funds on a monthly basis (drip feeding money)? Finally can you invest in these funds within an ISA?
Thanks for your replies.

MDW1954 07 Sep 2009 , 12:24pm


Elevate, part of AXA, have announced that they will sell the Vanguard products. The ISA answer is "yes", at least for the main FTSE trackers. I haven't looked in detail at all the Vanguard offerings.

Foolish regards,

Malcolm Wheatley

gordonbanks42 07 Sep 2009 , 1:24pm

Mistake 4 is picking a tracker that doesn't track very well. The TER will affect this, but so will other things about the way the fund is run. As a rule of thumb, big funds find it much easier/cheaper to track accurately than small ones do.

I would suggest that anyone evaluating a number of different trackers should look at some price graphs over the longest term they can find. Any difference in long-term price movement is due to tracking error. Put up the return from the relevant index on your graph too as a benchmark (remember to choose capital only or total return as appropriate). Avoid anything that looks conspicuously bad or good - tracking error cuts both ways.

Sorry to bang on about this, but one day - come the revolution - funds sold as trackers will by law be required to disclose tracking error figures.

@anshah : provided the up front charge is a % of the amount you are paying in (with no minimum) rather than a fixed £ amount, it should still be cost-effective to drip-feed.

I have read (but not checked) that someone offering Vanguard units was charging a fixed fee for each purchase - if true that would argue against drip-feeding, at least in small amounts. One way round that could be to drip-feed monthly into a different All-Share tracker that had no up-front charge (e.g. L&G) then switch in larger lumps into Vanguard from time to time. Depends on the cost of switching too, of course.

Fool277614858 07 Sep 2009 , 1:28pm

I have to add my vote for the L&G FTSE 100 Tracker. Two extra hints:
- If you wait till close to the Tax Year end there are lots of cashback offers. I invested in March '09 and will get the first year management fee in cashback in March '10.
- If you happen to be an L&G shareholder you receive additional cashback - so all in all I am paying close to 0% fees in the first year.

I have also spotted that Liverpool and Victoria are offering a £44 cashback via Quidco for any of their investment ISAs - plus online they reduce their initial fee from 5% to 2%.

I have to admit though, I do not fully understand the TER calculations, I tend to get swayed by low headline management fees and assume that because it it a tracker the fees must be lower than a managed fund.

And given the rise in the FTSE since March when i invested, it has proven to me that tracker funds can be just as profitable as any managed equivalent...

jerryrc 07 Sep 2009 , 1:36pm

Although not quite on the subject of fees, it pays also to look closely at what you're getting for the money. e.g last time I looked, the fund make-up of the Fidelity tracker showed over 30% in held cash, a serious drag on performance in the long run.

MDW1954 07 Sep 2009 , 1:46pm

Hello Jerryrc,

The Fidelity "cash" isn't cash, but "financial futures" tracking the index. It's counted as cash, but rest assured, it's not.

Foolish regards,

Malcolm Wheatley

gordonbanks42 07 Sep 2009 , 3:29pm

Financial futures carry counterparty risk, don't they? So a tracker with 30% exposure to such instruments will be more exposed to a Lehman-style meltdown than one holding 99% in good ole shares. Or perhaps the futures are bought through a clearing house and don't carry so much counterparty risk after all. How are we supposed to know what this stuff really is?

A4 07 Sep 2009 , 4:59pm

I have often wondered what happens to the dividends trackers earn?

gordonbanks42 07 Sep 2009 , 5:21pm

@A4: It depends what kind of fund it is and which kind of units you have. If it's an OEIC or an AUT then the divis are distributed to unit holders. The distributions are either paid out in cash (if you have income-paying units) or they're reinvested (if you have accumulation units). Usually, the fund's costs are deducted from the income first, so its only the remainder that's distributed.

Distributions don't happen every time the fund receives a dividend payment. The divi money received is pooled and then paid out (or rolled up) annually, semi-annually or quarterly, depending on the rules of the fund.

roarke80 07 Sep 2009 , 10:01pm

Thanks for this very useful article! I'm also looking at investing in the new Vanguard tracker via Alliance Trust. I believe it would be most prudent to invest via a monthly contribution cos of dollar cost averaging, but Alliance Trust charges £12.50 for every transaction!

Does that mean my only option is to put in a huge sum at one go and risk having invested at a higher price?

Thanks in advance!

MDW1954 08 Sep 2009 , 10:37am
MDW1954 08 Sep 2009 , 10:40am

Hi Roarke80,

I think the best place to ask this question would be on the Fool's Alliance Trust Savings discussion board. It's a new one, and there are some very knowledgeable people there.

Malcolm Wheatley

pdr65 08 Sep 2009 , 4:31pm

I hope you will allow me, as a Vanguard UK employee, to comment on this thread.

Overall its a well argued and a useful edition to the debate on trackers but one thing that has come up a lot since Vanguard launched is this question of our Stamp Duty Reserve Tax (SDRT) levy, ie the 0.5% upfront on our two UK Equity Index funds.

To quote our website "SDRT applies when UK stocks are bought and when shares of a fund investing in UK stocks are redeemed and subsequently re-issued". If the new investor doesn't pay the SDRT on their purchase the existing investors pick up the tab. There's a perception Vanguard charge SDRT upfront whereas others roll it into the TER: that's incorrect. SDRT is part of the transaction costs of running a fund and so is excluded from the FSA defined method of TER calculation.

We could remove the SDRT levy and still have the same TERs as now: it would eventually show up in the tracking error - see gordanbanks42 above - and long term investors would subsidise short term ones. That doesn't fit with our values or our desire for low tracking errors, instead we have a charge many others don't and we spend much time explaining it. Conversely where, eg US Equity Index, there's no equivalent of SDRT we have no upfront charge.

Peter Robertson, Head of Retail, Vanguard Investments UK, Ltd"

MDW1954 08 Sep 2009 , 5:24pm

Hello Peter,

I think the article makes it clear that the 0.5% charge isn't included in the TER, by making the point that the forward TER at 0.15% is the same as the annual charge of 0.15%.

However, I think you're right that there is generally some confusion around the issue.

I've another follow-up tracker item due in a week or so, and I'd be happy to speak with you before then. Please get in touch through the usual means!

Foolish regards,

Malcolm Wheatley

Fool1317999836 21 Sep 2009 , 5:39pm

Hello all,

This is my first post so take it easy on me =)
I am a 21 year old student and have only been researching opportunities for investment for about a two weeks, but I am determined to start investing now for the future.

Anyway basically from what I have read it seems like index funds are a good long term investment (especially with cost averaging over long periods of time.)

I have read lots about Vanguard and what a trusted and respected company it is and have been clicking away on its website and the Alliance Trust (the Vanguard provided investment platform) website.

I have a couple of questions though. I hope you guys can help me out :-

1. The Alliance Trust regular dealing charge is £5 and the flat rate purchase charge is £12.50. I think I can afford to invest about £100 a month.

I am having trouble working out how often I should invest though.
It seems to me you must get the best cost-average if you invest very regularly, but the charge of £5 eats into my investment. Which ratio is the best?

A. Invest every Month. £5 being 5% of my £100 investment
B. Invest once every 2 Months £5 being 2.5% of my £200 investment
C. Invest once every 3 Months\Quarter £5 being 1.6% of my £300 investment
D. Invest half yearly £5 being 0.83% of my £600 investment.
E. Invest yearly £5 being 0.4% of my £1200 investment.

I hope I am making some sense to you guys. I want to invest long term get a good average and at the same time not eat into my investments too heavily.

2. Is it un-recommended to only invest in Index funds or does their inbuilt diversity make them fine. someone said I should have my own age (21) worth of my portfolio in Bonds.


I think I will leave it there for the moment otherwise this post will get to long.

Thanks in advance for any replies they are really appreciated. As you can probably guess I cant afford my own adviser. hehe


Joseph Murray

Fool1317999836 21 Sep 2009 , 6:00pm

Oh yeah by the way can the fund - Vanguard FTSE UK Equity Index (shown on page 33 of the link below)
switch on request between being Accumulation to Income? They are both the same fund effectively aren't they? it just seems like the way the dividends are dealt with differ.

thanks again Joseph.

ajooba 03 Oct 2009 , 12:46am

I just stumbled upon this article.

Joseph, It is great you are starting out so early. Time in the market (not timing the market :) is your friend and the power of compounding will work in your favour. Regarding your question about asset allocation, visit bogleheads if you have not already done so : I recommend these for UK investors :

I am not aware of the £5 charge you mention for Alliance Trust. I had read somewhere about the £12.50 charge (trading fee per transaction), but I cannot find it now.

I am still confused about all the various charges with the Alliance Trust + Vanguard combination.

As per, for the UK Equity index :

Standard Initial Charge : 0.50%
ATS Initial Charge : 0.50% - What is this ??!!
Annual Management Charge : 0.15%

See above : is there an extra 0.50 (Alliance Trust Service initial charge) that is not mentioned at all in this article ?

Fool917804977 09 Oct 2009 , 9:39am

I work for Transact - a platform designed for financial planners in the UK to administer their clients' assets. We get to see what many financial planners are doing for their clients as we buy, hold, and sell the funds for them.

I thought you might be interested to know that a small but increasing number of good quality planners are turning to index funds (either 100% or alongside actively managed funds) such as Vanguard's for their clients.

Typically a planner will assess your attitude towards risk and your financial goals and then build you a portfolio of funds based on a certain asset allocation aimed at maximising your chances of meeting those goals.

Many of these planners and advisers have started using index funds from the likes of Vanguard to either build entire portfolios or as a 'core' with a 'satellite' of actively managed funds in certain areas.

Their thought process is that their role is changing from previously being investment advisers (ie people who are paid to pick out-performing funds) to financial planners whose job is to help their clients set and reach lifetime goals, where the funds are merely a tool to meet these objectives. In which case a long-term buy and hold strategy (with regular re-balancing) is becoming more appropriate.

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