Personal Finance: Trackers on a steady trail

Adventurous they are not, but with the Footsie in the lead, tracker funds perform well.

Investing in a tracker fund means that while you will never outperform the chosen market, you will never underperform either. Trackers leave little to the investment skills of a fund manager and rely instead on a simple formula - they either replicate their chosen index or else take a large representative sample of it, weighted accordingly.

Because they have no need for expensive fund managers, their costs are much lower than those of actively managed funds. And this means that they have a headstart when it comes to performing.

No wonder that over the past few years since becoming widely available, funds that track either the FTSE 100 or the much larger, and many would argue more representative, FTSE All Share Index, have proved to be very popular.

Virgin UK Index Tracking and Legal & General UK Index, which both replicate the All Share Index, are two of the largest UK funds, looking after more than pounds 3bn. Their performance figures, like other UK trackers, have consistently beaten most active fund managers, those who select their own portfolios.

It is not just in the UK market that you can buy tracker funds. Norwich Union and Scottish Widows offer global, international trackers while a number of groups, especially HSBC, Legal & General and Morgan Grenfell, now offer a range of funds that track various overseas markets. And just like their home-grown counterparts, they offer a cheap way into international investment.

However, a word of warning. While they can provide the first stepping stone in international markets for the more cautious investor, they show significant differences in their performance records against their active competitors.

"There are wide differences in how trackers perform in well established markets and how they do elsewhere," says Rob Fisher of HSBC. "Active fund managers find it harder to outperform the markets in the UK and the USA than they do elsewhere. In the USA only about 20 per cent will outperform the index, while in the UK it is usually about 25 per cent."

This difference is due to a number of reasons, the most important of which are the transparency of the markets and the instant availability of information to all investors. In other markets, however, it is more difficult. In the emerging markets of the Far East and Latin America, and even in the more developed European markets, there can be problems obtaining accurate financial information and dealing in equities. "In less efficient markets, active fund managers can find it easier to identify undervalued companies," says Mr Fisher. "But as markets become more efficient, this becomes more difficult."

Some of the overseas markets have indices with a built-in bias so that if a sector goes into rapid decline, this can lead to significantly poor performance. "This happened in Japan where banks and financials accounted for about a third of Tokyo's main index a couple of years ago," says Stephen Abbott of Legal & General. "Even now, with the refinancing of the Japanese banking system going on, the sector still amounts to just under 20 per cent of the index. In simple terms, it means that the weight of the sector has shrunk some 35 per cent."

No wonder that four in five of active managers have outperformed the trackers in Japan.

In overseas markets, trackers tend to be all-out growth funds since the markets they invest in offer little or nothing in the way of dividends. This means investors will be looking at total return, as there will be little to come in the way of income. These markets invest in companies included in the various recognised FT-S&P international indices. In contrast to the UK and the USA, they tend to buy the leading stocks rather than the whole index - an important reason for this is that the companies at the bottom end of the various indices tend to be very illiquid. This means that they can be difficult to buy and sell and that they often have very wide price-spreads.

"While we may miss out on changes in value, these are such a small percentage of an index that they will have little effect on overall performance," says Mr Abbott.

International trackers have a role for those investors who want to maintain core holdings overseas to which they can then add more active funds, as satellite holdings, when they become more sophisticated. "They provide a chance of entering a market at very low cost," says Mr Abbott. "With most trackers having no initial charge and lower annual management fees, it's like entering a race 10 metres ahead of the pack."

Or as Mr Fisher put it: "If you want to buy into a market but want to have a low involvement, an international tracker will give you a broad exposure to wide range of equities at a low cost, just as they do with UK funds. But if you want to do really well, then you need to look at both trackers and active funds."

In these days of ISAs and CAT-marks, however, there is another way for investors looking for a low cost entree into overseas markets. Unfortunately, active funds carrying the CAT mark are few and far between. Norwich Union is about the only leading investment group to offer this as an alternative to trackers. The company has a range of international open-ended investment companies - the modern version of unit trusts - with no initial charge, and also annual management fees comparable to the trackers.

"Charges and performance matter, they can't be taken in isolation," says Mark Skinner of Norwich Union. "With our funds, you start as far ahead in the race as with a tracker, unhindered by high charges. And with active management you have much more chance of outperforming an index."

Contacts: HSBC on 0800 289505; Legal & General on 01222 448412; Morgan Grenfell on 0171 545 7171; Norwich Union on 01603 204312; Scottish Widows on 0845 845 0088.