YOUR INTRO TO TRACKER FUNDS AND ETFS
In a recent webinar, I covered the merits of using Tracker Funds in your portfolio. They are gaining massive momentum and anyone looking for long-term returns MUST understand them. In the webinar I mentioned Warren Buffett’s views on traders.
Buffett – regarded by many as the world’s top investor – famously made a $1m bet in 2008 that a simple index fund would outperform five actively-managed funds over a period of time. Funnily enough, only one Fund Manager stepped up to the challenge.
The result? Over the course of the bet the S&P 500 index fund returned 7.1% compounded annually, significantly more than the basket of funds selected by the fund manager. That basket only returned an average of 2.2%.
Buffet’s biggest problem with actively-managed funds is that their performance doesn’t justify the high fees. But more on that later.
What is an Index Tracker?
Let’s first look at what an index is and how an index fund replicates the performance of a particular index.
An index here refers to a list of publicly traded companies within a specific market. For example, the FTSE 100 is an index composed of the 100 largest companies (by market capitalisation) listed on the London Stock Exchange.
The aim of an index fund is to track and replicate the performance of the specific index, by investing in the companies quoted on it.
Say you invested in an index fund tracking the FTSE100, if the FTSE goes up by 3% as a whole, your investment will go up accordingly. It’s a very straightforward investment option - your only decision is which indexes to track.
I keep hearing about ETFs - are they they same thing?
Index funds should not be confused with ETFs – Exchange Traded Funds. Although both aim to replicate the performance of an underlying index, there are two key differences: flexibility and pricing.
Index funds are priced once a day, after the markets close. ETFs, on the other hand, can be traded throughout the day like stocks and the pricing is determined by supply and demand for the securities.
FYI - most of my portfolio uses ETF trackers.
So why should I use Index Trackers and/or ETFs?
As touched upon before, the biggest benefit of investing in an index fund or an ETF, as supposed to individual stock picking and actively managed funds, is cost-savings.
Index funds are passively managed so there’s no fund manager’s fee to pay. As a result, they are much cheaper to invest in, with some funds in the UK starting as low as 0.06% p.a. In comparison, actively-managed funds start at 1% and above, often coming with hidden charges to boot.
In most instances, these high fees are not justified. It is estimated that more than 80% of managed funds failed in beating the market over the past 20 years. Your chances are therefore very low at choosing an actively-managed fund that will do better than a market-related index fund.
The diverse investment nature of tracker funds also means that the assumed risk is reduced and it’s less susceptible to political movements like Brexit. For example, on the day of the Brexit results, UK index funds fell by 6%, while actively managed funds dropped by 8%.
Another benefit is that they can be easily managed and therefore you don’t need to become an investment geek to use them. For this reason, I think they are well worth considering for most people looking to supplement their pensions and get decent returns over a long period. This is especially true if you don't want to put time and effort into other investment options such as property, individual stock picking or starting a business.
Whatever your reason for choosing to invest in an index tracker, you’re in good company, from Warren Buffet to Richard Branson, all acknowledging the benefits of adding this investment option to their portfolio.
Do you have ETFs or Index Funds in your portfolio? Let me know in the comments.