Bloodhound for the markets

The fact is that even the most experienced investor can benefit from having a tracker as part of their core portfolio, for one simple reason – cost. In terms of fees, trackers are one of the cheapest ways to gain access to the markets. Unlike active funds with a ‘traditional’ tracker there is no manager or highly skilled bank of analysts to pay. Essentially it comes down to something of a ‘black box’.

That is the theory, and by and large it is the case. However, some trackers are more expensive than others, and with the division of fund management fees following the introduction of the retail distribution review at the beginning of 2012, we have seen downward pressure on the charges levied by various tracker funds as competition to be the lowest charging tracker has emerged. But when considering charges it is also important to consider ‘total’ charges including, for example, platform fees.

With an index fund the traditional tracker or physical ETF simply buys the stocks in whatever index the fund is tracking in the same proportions, generally speaking, as they appear in the index – although different methods such as full replication, stratified sampling, optimisation or synthetic replication can be used to achieve this.

The funds are typically run by computer model, rather than managed actively by a fund manager, so all fund management decisions are taken out of the equation and performance is not affected by the subjective decisions of a fund manager. Of course, if an active fund manager makes the right investment decisions investors get a good deal, but if he or she gets it wrong it is the investor who, literally, pays the price.

Index trackers could well be termed bloodhound funds

Although trackers linked to, for example, the FTSE100 and FTSE All Share are commonly perceived as low-risk equity investments as they purchase predominantly large to mid-cap stocks in a mature market, there are those who argue the very opposite. There is a view that tracker funds are more volatile than active funds as they are fully invested – they go further on the ups but also further on the downs.

Index trackers could well be termed bloodhound funds. By this I mean they sniff the market all the way up and all the way down again. There is no intervention by a fund manager. With an actively managed fund the fund manager can potentially move to minimise losses in a bear market by, for example, building up cash reserves.

Then there is the fact that trackers linked to indices such as the FTSE 100 should not, in my opinion, be considered low-risk as the index is dominated by a small number of core companies in certain industries. When selecting a tracker a fundamental decision to make is what index you wish to track. When looking for a ‘target index’ a decision must be made as to what, in the opinion of the adviser/investor actually constitutes, for example, the US equity market.

One might use the Dow Jones Industrial Average, the S&P 500, the Russell 3000 or the Wilshire 5000. The Wilshire 5000 is generally recognised as the best overall barometer of the US equity market as it contains approximately 98 per cent of all US headquartered equity securities while an index such as the S&P 500 is, by definition, overweight in the biggest securities within the market by market capitalisation.

In order to address some of these issues we have seen the introduction of collectives and ETFs that track fundamental indexes rather than standard indexes. Fundamental indexes weight stocks according to measures such as earnings, dividends or perhaps sales, rather than by market value.

In addition to fundamental trackers we have also in recent years seen the introduction of ‘factor investing’. Factor investing means looking for specific characteristics (factors) shared by groups of stocks that make them more likely to beat the market.

Widely recognised factors are value (for example, price/earnings and price/book ratios), size (for example, smaller companies have historically beaten larger ones), momentum (stocks that have done well in the recent past are likely to keep outperforming), low volatility (believed by some to outperform high volatility shares over the long term) and quality (for example, traits such as low levels of debt and high returns on equity).

Factor investing ETFs have become popular with some investors as a potential middle ground between passive and active investing.

My view is that investment is ultimately simple but not easy. But it must not be forgotten that ultimately investment involves various active decisions. For example, what percentage of your assets should you invest in shares, fixed interest and property, and then within the allocation of, say, shares, what percentage to the UK and then within the UK allocation, what percentage to large or small cap; or if following a factor approach, what percentage to various factors?

For me, the selection of appropriate funds and asset allocation decisions is best done as part of an end-to-end investment proposition starting with agreeing a risk profile/capacity for loss and ending with an appropriately populated asset allocation, be it using trackers/ETFs or active management or whatever.

Andy Gadd is head of research of Lighthouse Group

Key points

Even the most experienced investor can benefit from having a tracker as part of his core portfolio.

With an index fund the “traditional” tracker or physical ETF simply buys the stocks in whatever index the fund is tracking in

we have seen the introduction of collectives and ETFs that track fundamental indexes rather than “standard” indexes