Money: Don't spin off track

Index-tracking plays better at home than away, writes Juliet Oxborrow

TRACKER funds used to be a little-known type of investment fund mostly used by big investors such as managers of pension funds. But thanks toRichard Branson's Virgin and others, as well as the strong performance of UK tracker funds over the past three years, they are now one of the best-known types of stock market investment among private investors.

Trackers are normally unit trusts that aim to match the rise and fall of a particular stock market index by buying its constituent shares, rather than trying to outperform the underlying market. Trackers following UK indices such as the FT-SE 100 or the FT-SE All-Share have become hugely popular, but funds tracking foreign stock markets are also available.

HSBC and Legal & General are among the leading providers of foreign tracker funds. Both offer trackers following Japan, the US, Europe and, in HSBC's case, the tiger markets of Asia. AIB Govett withdrew a number of its foreign trackers in the autumn because of lack of demand, but still offers two funds that track the US market by using futures contracts rather than buying individual shares. Norwich Union offers an international tracker aiming to replicate the FT/S&P Actuaries World (excluding UK) index.

The popularity of UK trackers partly reflects their lower charges. They are cheaper because there is no need to employ a highly-paid manager to decide investments or spend on research. In addition, if the index is being replicated properly, the fund should not underperform the market. In practice that has meant good returns compared with those funds with the more ambitious aim of trying to outperform the underlying index.

Foreign-market trackers are certainly cheaper than actively managed counterparts. Norwich Union's International Tracking Fund has an annual charge of 0.9 per cent compared to 1.25 per cent for the Norwich International Trust. Annual charges on HSBC's tracker funds are 0.5 to 1 per cent lower than on its active funds.

But there are signs that foreign trackers are not as strong on performance. UK trackers have topped their sector, but trackers following markets like Japan, the Far East and Europe have posted below-average returns for their sectors, and sometimes failed to keep up with the index they are supposed to track.

Part of the problem is said to be that indices in regional markets like Asia and continental Europe are impossible to replicate fully because they include too many shares. The best managers can do is partially replicate the index. Liquidity is also a problem, particularly in Japan - managers cannot always trade stocks when they need to.

Some professionals believe the success of index-tracking depends on the nature of markets. Robin Minter-Kemp, deputy managing director of HSBC Investment Funds, says index-tracking works best in mature, well- regulated markets such as the UK and US. "But in the Far East and Japan, where information is given on a need-to-know basis, active fund managers can really add value and discover good stocks."

Graham Bates, of Bates & Partners, independent financial advisers, agrees. "Active stock-picking is much more important in Far Eastern and even European markets because there are more anomalies to exploit."

Mr Bates cites research from HSW, a performance measurement company, showing that active (non-tracking) funds have a better history of outperformance in newer foreign markets.

Funds investing in volatile markets also benefit from an active manager who can avoid the most troubled sectors. Japan is a prime example, where fund managers are keeping clear of banks, which have run into massive debt problems. Actively run Japanese funds may still be falling in value, but not always as far as trackers, which have no choice but to hold banking stocks. "Trackers have no defence mechanism," Mr Bates says. "They cannot avoid the bad news in a troubled market." He believes this inflexibility may prove a problem for UK trackers as investors look for better value by shifting from the safer but highly valued blue-chips to medium-sized and smaller firms.

Guide to making your investments work for you

Competition for investors' money is set to be intense this spring as companies try to convince the public to buy a PEP in preparation for switching into Individual Savings Accounts next year. But PEPs are not the only investment choice. The Independent on Sunday's new free guide is aimed at helping you to find the best deal.