An index tracker is essentially a cheap, simple investment fund that mimics the performance of the stock market. But, in order to understand how they work, it’s useful to know a little bit about stock market indices

Whether index trackers are better than managed funds is the cause of a fair amount of controversy in the world of investment. The evidence is fairly clear cut however, and it shows that index trackers beat the vast majority of managed funds over the long term

For instance, a study by research firm WM Company found that 82% of managed funds failed to beat the market over the course of twenty years. While you may think that sounds bad, it’s actually even worse, because this figure only includes funds survived for the whole twenty years – many poorly performing funds are shut down or get merged into other funds

This means that the chances of picking a fund now that will do worse than the market over the next twenty years is likely to be a lot higher than 82%, and is probably well in excess of 90%. Some people, however, believe that it’s possible to consistently pick one of the few funds that will beat the index, although this is obviously hotly debated

But what exactly are these index tracker funds tracking? How does an index work?

Britain’s most famous index: the FTSE 100

Most investors in Britain are very familiar with the name FTSE (pronounced ‘footsie’). The FTSE 100 is one of the most widely-quoted stock market numbers on all our news programmes and in our newspapers

The FTSE 100 is a stock market index. An index is simply a way of measuring the overall value of a range of companies or other assets, according to some underlying rules

For the FTSE 100, the index is made up of the 100 biggest stocks listed on the London Stock Exchange. They are ranked by ‘market capitalisation’ (market cap), which is a simple way of working out their financial size. Market cap = the share price x number of shares outstanding

The bigger the market cap, the bigger the portion of the index the company accounts for. In the jargon, the company has a heavier ‘weighting’

So if the price of the company at the top of the index moves, the impact on the FTSE 100 figure will be much greater than if the price of the 100th company in the index moves

The FTSE 100 is not the only index of London-listed stocks. There’s the FTSE 250 (the next 250 largest stocks) and the FTSE 350 (the FTSE 100 plus the FTSE 250)

Then there’s the FTSE All-Share, which comprises more than 600 stocks in total, including the FTSE 350. Despite its name, the All-Share index doesn’t include all companies listed on the main London market – there’s a FTSE Fledgling index for ones that are too small to qualify for the All-Share

There are also various indices based on the Alternative Investment Market (AIM), which is the London Stock Exchange’s market for smaller companies hoping to raise money to expand

Beyond the UK, there are stock market indices for every major (and most minor) economies. In the US, the best known are the Dow Jones Industrial Average (30 of America’s top companies) and the S&P 500 (the top 500 listed American companies)

Japan, meanwhile, has the Nikkei 225 (the biggest 225 stocks on the Tokyo Stock Exchange) and the Topix (which tracks around 1,700 companies)

There are also indices that track the price of commodities, and ones that track bond prices

Index trackers

An index tracker is a fund that holds shares in the same proportion as an index. So a FTSE 100 tracker attempts to mimic the performance of the FTSE 100 and so on. When the make up of an index changes, the index tracker will adjust its holdings accordingly. So an index tracker differs from most other funds, collectively referred to as managed funds, where it’s the fund manager who decides when and which companies are bought and sold

It is often difficult for the fund to exactly mimic the changes in an index, as they may not be able to buy or sell shares at the same price as included in the index calculations. These differences cause what is known as tracking error, which is simply a measure of the difference between the performance of an index and an index tracker that follows it. In practice though, these differences tend to be very small

The difference in returns

If an index tracker were to perform, say, 1.5 percentage points better each year than a managed fund, what difference could this make to you? Let’s say you put £1,000 into a tracker and £1,000 into a managed fund. The former grows at 10% a year, the latter at 8.5% a year

After ten years your managed fund would be worth £2,261 but your tracker would be worth £2,594. Over twenty years the managed fund would grow to £5,112 and the tracker would be worth £6,728. So your extra 1.5% a year return results in 24% more cash for you at the end of twenty years

As well as a higher expected return, index trackers have one final major advantage over managed funds — they are much simpler to operate. Essentially, you can just pick your tracker and leave it to do its job for twenty years or even longer

Watch out! Make sure you know what an index is doing

Index trackers seem foolproof. However, if you do decide you want to invest in a fund that tracks an index, it’s extremely important to understand how the index works

For example, basing an index on the size of the companies involved – as the FTSE 100 does – can give rise to some potential problems, or at least, misunderstandings

If you buy a passive fund that tracks the FTSE 100, you might imagine that you are getting equal exposure to 100 different companies

You’re not. The top ten companies in the FTSE 100 consistently account for more than 40% of its value. And three of the top ten are oil and gas companies. So in fact, you’re making quite a concentrated bet on a small range of companies

Now, this may be exactly the bet you want to make. But the point is, it’s very important to understand what you’re buying before you invest in anything

Also, because companies become more dominant as their share price goes up (and their overall value rises), a FTSE 100 tracker fund actually buys more stock as a company gets more expensive, and sells as it falls in value. So instead of ‘buy low, sell high’, a tracker fund buys high, and sells low

Even with this inherent problem, tracker funds still tend to beat actively managed funds. Which is an even more damning indictment of active funds!

So if you have any tracker funds in your portfolio just now, do make sure that you know exactly what those funds are giving you exposure to