I<\/span>ndex trackers \u2013 also known as index funds \u2013 are the investment vehicle of choice for passive investors<\/a>.<\/p>\n Why? Because index trackers<\/strong> provide a low-cost way to build a diversified portfolio that will outperform the average active investor<\/a>.<\/p>\n Index trackers come highly recommended by some of the biggest names in investing.<\/p>\n Yale\u2019s famed endowment fund<\/a> manager, David Swenson, neatly summed up the advantages<\/a> of trackers:<\/p>\n \u201cWith all assets, I recommend that people invest in index funds because they\u2019re transparent, understandable, and low cost.\u201d<\/p>\n<\/blockquote>\n Even Warren \u2018Gazillionaire\u2019 Buffett says index funds are the best<\/a> investment vehicles for most people.<\/p>\n Like other funds, tracker funds enable lots of investors to club together to increase their buying power. They collectively buy shares or other assets across many more companies than any individual could.<\/p>\n For example, index trackers make it possible to invest in all the world\u2019s stock markets via just one global tracker fund<\/a>.<\/p>\n Trackers are therefore a good way for everyday investors to get into the stock market without exposing themselves to the dangers of individual stock-picking.<\/p>\n Risks and costs are reduced thanks to the scale and diversity of the fund.<\/p>\n And while you\u2019ll never beat the market you\u2019re tracking with an index fund, you won\u2019t lag it by much, either.<\/p>\n Most funds have an aim. The aim of a tracker fund is to reproduce the returns of a specific market index.<\/p>\n An index is a basket of securities (such as shares or bonds) that is used to represent a particular segment of the market.<\/p>\n Famous indices that you\u2019ll have heard of on the news include the:<\/p>\n An index is rather like a scoreboard or league table. It provides a systematic way of measuring how a particular market is performing.<\/p>\n There are many weird and wonderful indices out there, from the All-Peru index to the Volatility Arbitrage index.<\/p>\n But virtually all of us only need to concern ourselves with the very biggest ones.<\/p>\n You need to decide:<\/strong><\/p>\n You can then make an informed choice about which tracker to go for.<\/p>\n For example, global equities are covered by a number of indices. Some of the most popular are the MSCI World<\/strong>\u00a0and the FTSE Global All Cap<\/strong>.<\/p>\n UK equity is similarly covered by a number of indices. The two most popular are the FTSE 100<\/strong>\u00a0and the\u00a0FTSE All-Share<\/strong>:<\/p>\n If you wanted the most diversified UK index, you\u2019d pick the All-Share.<\/p>\n However we believe that a global index fund<\/a> should be at the heart of most UK investors\u2019 portfolios. That\u2019s because with this single fund your money is diversified<\/a> into thousands of companies from across the world.<\/p>\n You can find out which index a tracker mimics by reading<\/a> its fund factsheet or web page.<\/p>\n Indices are created and managed by private companies such as FTSE Russell<\/a>\u00a0and MSCI<\/a>.<\/p>\n These outfits define markets slightly differently, which is why their respective \u2018global trackers\u2019, for example, won\u2019t own exactly the same companies.<\/p>\n You can even invest in funds that track (supposedly) more ethical<\/a> versions of their indices, tweaked to reduce exposure to, say, oil and gas companies or cigarette makers.<\/p>\n However because these niche indices differ from the broader markets, you can expect to earn a slightly different return when you go down this route \u2013 for better or worse.<\/p>\n One thing that surprises new passive investors is that an index typically doesn\u2019t give every company an equal weighting.<\/p>\n Instead, most indices are weighted by market capitalisation \u2013 or \u2018market cap\u2019.<\/p>\n The bigger a company\u2019s market cap, the larger its place in the index.<\/p>\n Let\u2019s say we have an index containing just three firms. If Company A is worth \u00a3700 billion, Company B \u00a3200 billion, and Company C \u00a3100 billion, then:<\/p>\n As share prices rise and fall, those weightings then change automatically. A company whose value doubles becomes a bigger part of the index. One whose fortunes decline occupies less space.<\/p>\n Market-cap weighting reduces trading, which helps keep costs down. It also reflects where investors have collectively put their money \u2013 a wisdom of crowds<\/a> approach that typically does better than striving to outsmart the market.<\/p>\n The downside is that today\u2019s biggest firms dominate even the broadest trackers.<\/p>\n At the time of writing, a global equity index is heavily weighted to US technology giants<\/a>, simply because they account for such a large share of the world\u2019s listed stock market.<\/p>\n Not everyone<\/a> is comfortable with this level of concentration, fretting that it leaves them exposed to the fortunes of a handful of super-sized companies.<\/p>\n It\u2019s worth mentioning though that if tomorrow\u2019s winners emerge from elsewhere in the market, then the index will gradually adjust to reflect that, too.<\/p>\n A tracker\u2019s job is to deliver the return of its index.<\/p>\n It usually does this by holding stocks (or other assets) in proportion to their presence in the index.<\/p>\n Some trackers will hold the lot, some only a sample, and yet others will replicate index returns using more complicated financial products<\/a>.<\/p>\n These differences in methodology help explain tracking error<\/a> \u2013 the extent to which a tracker fails to accurately track its index in any particular year.<\/p>\n Other drivers of index fund performance include the fees they charge investors and the fund provider\u2019s costs of running the fund and buying and selling<\/a> assets.<\/p>\n Tiny differences can see two funds that track the same index delivering slightly different returns over time \u2013 although rarely by enough to sweat the difference.<\/p>\n The key point is that trackers don\u2019t try to pick the winners<\/strong>. They don\u2019t market time.<\/p>\n They just plod along tracking the index, handing over the returns due from the performance of its component securities.<\/p>\n By its very nature, a tracker fund will never hit three cherries on the fruit machine. It will never turn in a stellar index-trouncing result.<\/p>\n Its task is just to replicate the index.<\/p>\n In fact, a tracker will usually undershoot its benchmark, due to fund costs.<\/p>\n But a tracker\u2019s limited ambition makes it cheap to run<\/strong>. And it\u2019s because they are cheap<\/a> that most trackers outperform<\/a> expensive active funds in the long run.<\/p>\n There are two main types of tracker funds:<\/p>\n You can read more about the different types of tracker<\/a> in our\u00a0archives.<\/p>\n We also keep a watching eye on the lowest-cost index funds<\/a> for UK investors.<\/p>\n Take it steady,<\/p>\n The Accumulator<\/em><\/p>\n p.s. This article on index trackers has been updated after ten years hard labour. Comments below are preserved for posterity but may be out-of-date. Check the date!<\/em><\/p>\n<\/p><\/div>\n\n
Safety in numbers<\/h3>\n
![\"Index](\"https:\/\/i0.wp.com\/monevator.com\/wp-content\/uploads\/2010\/10\/7.-How-an-index-tracker-works.png?resize=499%2C508&ssl=1\"){kind=tracking}
<\/a><\/p>\nIndexes in (just a little) detail<\/h3>\n
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Whose indices are they, anyway?<\/h4>\n
Some firms are bigger than others<\/h4>\n
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Gain with less pain<\/h3>\n
How trackers win by being average<\/h4>\n
Types of trackers<\/h3>\n
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