Investment: Tracking down the right fund

IT IS all very well going on about index funds, a number of readers have written in to say, but how does one find a list of tracker funds and how does one choose between them? These are good questions. The answer to the first question (somewhat surprisingly) is "not very easily". The answer to the second is more straightforward. This column sets out to explain one way of filtering the available options to a manageable number.

Tracking down a comprehensive or detailed list of tracker funds is not as easy as it should be. I have not yet found a retail publication which regularly lists tracker funds as a category in their own right (any aggrieved publisher who knows better is welcome to put me right). There are a number of websites which give you part of the answer, but these too tend to suffer from similar drawbacks, being either incomplete (eg the otherwise creditable ISA service at the Moneyextra.com site) or complex and time- consuming to manipulate (like Micropal's website).

Index funds are still relatively new in this country, but their numbers are proliferating fast, and consequently demand for more regular information on where and how they can be found is likely to follow. Most independent financial advisers and other professional advisers have access to more sophisticated data services which allow them to categorise and manipulate fund data to isolate tracker funds if they so choose.

Using the latest monthly performance data from one of these (Micropal's Fund Expert) as the base, I have been looking at the state of the index tracking business in the unit trust/Oiec (open ended investment company) sector. (For this exercise I ignore the two UK tracker fund investment trusts, Edinburgh and Tribune, though both rate a look). As at 31 July, according to Micropal, out of 270 unit trusts and Oiecs in the UK All- Companies equity sector, there were 49 tracker funds. Of these no fewer than nine have been started since the start of this year. Barely half have been round long enough to compile a three-year track record. The two biggest funds are run by Virgin and Legal and General. Between them they have more than pounds 3,300m of investors' money.

How to break this growing list down to manageable proportions? Step one is to eliminate funds with such high minimum investment requirements that they will be of interest only to institutions or high net worth individuals. Eight of the 49 UK tracker funds go out because they require a minimum investment of pounds 100,000 or more. I have also excluded the one fund with a pounds 25,000 minimum. The 40 funds that remain all require a minimum investment below pounds 5,000. Eleven funds require no more than pounds 500 as a minimum investment. About half have regular savings schemes.

The next step is more controversial. To my mind, it makes no sense to pick a tracker fund that seeks to charge you on the same basis as if it were an actively managed fund. The whole point of tracker funds is that they work primarily because they are low cost. They are (or should be) seen as commodities. Other things being equal, the fund with the lowest costs should therefore stand ahead of a higher-cost fund.

My screening exercise therefore, throws out all funds which have a bid/offer spread, an initial charge of any kind, and an annual management charge of more than 1 per cent per annum. The only exceptions I make are funds where the bid/offer spread and annual management fee combined come to 1 per cent or less (This lets back in the Gartmore and Dresdner funds, but excludes HSBC's All-Share tracker by 0.01 per cent). This reduces the range of possible funds from 40 to 9.

Next decision is to choose which index to track. Ignoring the four funds that track the FT 250 or FT 350 indices (neither of which appeals to me conceptually), the basic choice is between the 100 index and the All-Share index. Until last year, the FTSE 100 index had strongly outperformed the All-Share index; that trend has reversed. Over time the two will tend to equalise, so for long-term investors it makes little difference. My preference, on technical grounds (too dull to go into) is that an All-Share tracker fund is a better bet.

What else remains? A lot of time and effort can go into analysing how efficient different tracker funds are at tracking their respective indices. I have seen services that measure tracking error and the risk/return characteristics of the fund relative to its index. (For the record, ARC/Lipper awarded top marks to the Direct Line tracker fund on this measure). Another way is to look at performance and volatility as a package. A fund whose volatility is above that of the index it is tracking implies a tracking error greater than that of a fund whose volatility is less. Note that the Footsie tracker funds tend to have higher volatility than All-Share funds, commensurate with their higher returns. Note also that Fidelity's Moneybuilder index fund, while an excellent fund, cannot be compared directly in performance to the other Footsie funds since it has changed the index it tracks.

I have to say that unless a tracker fund's performance and volatility are significantly out of line with the index, I am not convinced that it is such an important factor. Tracking is an art, not a science, but the margins created by differences in skill are relatively small. Provided you are investing with a high-quality fund management group, it really should not be a factor. Annual fees are likely to be more important over time. So too is the quality of the after-sales service provided by the management group. This is an area on which there is precious little research available at present.

If you spread your money across three or four groups, you will quickly learn which are courteous, efficient and prompt in handling inquiries and paperwork, and which are not. Most insurance companies start with a negative drag in this respect. The table lists the nine tracker funds that pass my criteria and have records stretching back at least three years. Newcomers to watch in my view include the index funds offered by Equitable Life (very cheap as you would expect), Royal and Sun Alliance, and Tesco.

davisbiz@aol.com