Follow that share

Simon Read charts the rise to prominence of index-tracking funds, which promise security, simplicity and lower charges

Highly paid fund managers have had to face a new challenge over the past couple of years - a challenge that an estimated two-thirds of them have failed to meet. It is the growing popularity of index-tracker funds, which have been aggressively promoted by new faces such as Direct Line, Marks & Spencer and Virgin Direct.

Their success is evident. With lower charges and easy-to-understand investments, thousands have signed up, and more than pounds 3bn is now invested in tracker funds. Why? Because, as long as shares are rising, an index- tracking fund will follow. Actively managed funds, on the other hand, carry no such guarantee, no matter how experienced the fund manager.

Charges are one of the main reasons that index-tracker PEPs have become so popular. Traditional actively managed funds have up to 5 per cent initial charges, plus an annual fee of around 1.5 per cent.

Index trackers have done away with initial charges and have annual management fees of around 1 per cent. But they also promise simplicity. Investors do not need to understand different investment strategies or even the nature of different markets. Biotechnology, for instance, has been a talked- up investment area but who understands the nature of this field? Frankly, it seems a little unwise to invest in something you know nothing about.

One of the beauties of index trackers is that you should get the best of all investment worlds in that you will be investing in a wide variety of shares across the index. Where index trackers vary, however, is in which index they track.

The simplest and most obvious index is the FT-SE 100. Known colloquially as the Footsie, it is simply the index of the top 100 shares in the UK. All the shares are blue chip and will generally be household names, such as Marks & Spencer and Sainsbury's.

They therefore offer a degree of comfort for novice investors as they are unlikely to be companies that will collapse, although there is no guarantee that this will not happen. But the nature of index tracking, which means investing in a wide number of different shares, means that even if one company does collapse, the fund's value should be maintained by other holdings.

It is the popularity of the Footsie that makes it an obvious choice for index-tracking fund managers such as Direct Line. "The Footsie is well known; it's mentioned in the news most days and even papers like the Sun chart its performance," says Robert Allen, investment products manager at Direct Line Life, which launched its PEP just over a year ago and now manages around pounds 24m.

Direct Line chose to mark its entrance into the world of investment with an index tracker for a number of reasons. "Over most periods of time the theory has proved itself, that actively managed funds underperform the market," says Mr Allen.

An index-tracker fund is therefore obvious on the basis that if you cannot beat the market, why not match it? Virgin Direct took the same approach two years ago and has successfully built up a fund managing over pounds 500m, with more than 100,000 customers.

The difference between many funds is how they choose to match the market. Some PEP managers, such as Legal & General and Gartmore, invest in just a few shares to try to match the whole market.

The shares are chosen on an historical basis, as those which have in the past best matched the market performance. However, the wrong stock choice can leave these trackers a long way off the index.

That is why many index trackers go for full replication of their chosen index, which means holding shares in every single listed stock. "It means our fund will accurately reflect the market," says Mr Allen.

Tony Wood, a marketing director at Virgin Direct, echoes this view: "Full replication gives a massive advantage, while sampling means that guesswork comes into play." Virgin Direct tracks the FT- All Share index, which includes more than 900 shares. "It means we can offer cost effectiveness to get a real level of diversification in the fund," says Mr Wood.

However, partial replication means fund managers can be more fleet-footed when it comes to buying stocks, rather than slavishly having to follow the index. Virgin Direct says it is easier and cheaper to track the smaller Footsie, but that by doing so, investors could miss out on higher potential returns.

"When we launched our fund, we examined where customers would benefit most in the longer term," Mr Wood explains. "The fact is that investing just in the FT-SE 100 would mean missing out on the high potential offered by many of the smaller companies in the All Share."

It is that potential which encourages other tracker funds to venture even further afield. There are index trackers covering Europe, such as the Legal & General European Index; the US, such as the Govett US Index; and Japan, such as the HSBC Japan Index. So, are index trackers the answer for everyone?

No, says Mr Wood. "The trade-off with index trackers is that you are getting the market return and you'll never experience spectacular results. It's a question of deciding how much potential return you are giving up to reduce the risk."