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Index tracker funds

What is an index tracker fund?

An index tracker fund aims to replicate the returns of a given market index as closely as possible, by investing in the securities that make up that index. A key advantage of this approach, compared with actively-managed funds, which aim to outperform a benchmark, is that it eliminates the risk of significant underperformance of the index in question.

An index fund will provide exposure to individual constituent companies and their industries in the proportions in which they are reflected in the associated index. As such the performance of any index constituent would be reflected equally in the performance of both the underlying index and the index fund.

"Investors must be mindful that, while some indices may have similar names, their risk and return characteristics can be different."
 
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An index fund manager will not vary the fund weights from the underlying index and will not, for example, increase its exposure to cash if the market is expected to fall. Equally, index fund managers will not seek to vary exposures to certain companies or whole sectors in order to reduce concentration risks.

As an example, as at 31 January 2015, five energy companies and five banks make up 26.9% of the FTSE 100 index. Depending on the outlook for the energy sector and other areas of the underlying market, the level of risk in the index fund will rise or fall in line with the risk in the index and the manager will have no discretion to vary that.

Choosing the right index

Different index providers have different criteria for including stocks. Subsequently, indices are not the same. While some indices may cover the same region, country or an asset class as a whole, differences in classification and rules often lead to differences in composition and performance.

Ultimately, there are no rules set in stone on how stocks should be categorised. As such, there is a degree of subjectivity in how each index provider chooses to represent a certain market. Investors must be mindful that, while some indices may have similar names and would seem to reflect the composition and performance of the same market, their risk and return characteristics can be different.

What should I look for in a passive fund provider?

There are several key factors to consider when choosing the right passive fund provider for your and your clients’ investment needs:
* Experience
* Scale
* Index methodology
* Tracking performance / tracking error
* Costs
* Commitment to innovation

As an example, some providers, such as MSCI, include real estate investment trusts and preferred shares with equity characteristics in their indices. In contrast, FTSE does not consider those investment securities, which in this instance would lead to a smaller property sector exposure. Providers also use different methodologies to identify and separate large-cap stocks from the rest. A number of indices automatically exclude newly-listed companies, while requirements in respect of the level of liquidity for a stock can also be different.

In turn, this means US equity index funds, for example, that track different indices will differ in terms of their short-term volatility and long-term performance. While two index funds might have similar names, sometimes their underlying indices may vary in terms of the investment universe they cover.

Why is there a difference in the performance of an index fund and the index it tracks?

Regardless of the index a tracker fund tries to replicate, there will always be some difference between the performance of the fund and its underlying index. In absolute terms, this is known as ‘tracking difference’, or as ‘tracking error’ if it is measured over a period of time.

This is because all replication methods incur some dealing and trading fees as portfolios need to be periodically rebalanced to accurately reflect the composition of the index being tracked. The resulting costs are deducted from fund returns. That said, it is worth bearing in mind that larger passive fund managers are able to achieve greater economies of scale, which can lead to lower costs for clients.

Global passive fund managers also need to maintain and develop relationships with traders and brokers around the world, to ensure best execution and low trading costs. It is also in passive fund managers’ interests to have a local presence in key global trading centres, so they can keep up to date with changing regulations and understand exactly how local markets work.

This article is based on Index tracker funds, an HSBC Global Asset Management guide. To see the firm’s library of passive-related guides and other literature, please click here

Who should consider investing in index tracker funds?

* Investors who have a positive long-term outlook for a particular market, such as European or emerging market equities
* Investors who would like to take a shorter-term tactical call on a particular market, such as the US or the UK, or a specific sector within a single country – for example, mid-caps or large-cap stocks within the UK market
* Investors who are comfortable with being tied to the performance of one index
* Investors who prefer the transparency that comes with meticulously following the performance of that inde
* Investors who are prepared to take on market risks in order to grow their wealth
* Investors who prefer a more diversified way to invest compared with a focused portfolio or single stocks
* Investors who do not feel comfortable with entrusting the performance of their portfolio to a fund manager aiming to deviate from the performance of the underlying market

 

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