Index Trackers
Passive investing is usually done through an index tracker. An index tracker is a passive stockmarket fund. It’s passive because there are no managers making investment decisions, it's simply following an algorithm to track a designated stockmarket index.
Stockmarket indices are things like the FTSE100 or the S&P500 which contain a whole variety of different companies and are used to judge how well the stockmarket as a whole is doing. Generally the bigger the company the bigger the percentage of the index it is – so if you buy an index tracker you’re buying shares in the same percentage as they make up the index. You will generally be buying a very broad base of shares which gives you what is known as diversification.
If the stockmarket index goes up so does the value of the fund. If it goes down so does the fund.
Index Tracking Advantages
There are a couple of advantages to index trackers:
1. Three quarters of all managed funds do worse than the index in any given year. So you have a 3 in 4 chance of picking one that does worse than an index tracker.
2. Their costs are lower than managed funds because they’re simple to manage. A lot of managed fund underperformance is because of the management fees that need to be paid.
The argument given against using index trackers is that they give you no chance of outperformance compared to active funds. That’s a weak argument – if you’re capable of identifying which active funds will outperform the market you should be capable of investing directly in shares anyway.
Selecting an Index Tracker
There are all sorts of indices and you need to be careful which one you select. The investment industry is now making up indices to track against and some of these offer very little in the way in diversification. So if all want is to invest in the stockmarket you need to look for one tracking a big and standard index.
Once you’ve decided what index to track then all you’re looking for is the Total Expense Ratio (TER) and tracking error rate. The tracking error rate tells you how closely the fund tracks the index. No fund can be an exact replica of the index but the good ones should get pretty close.
The TER is the combination of all the fees that the fund takes as a percentage of the overall fund value. The big US funds can get down to around 0.25% (a quarter of a percentage point) but anything under 0.4% isn’t bad. For similar TERs choose the fund with the lowest tracking error rate.
Different Sorts of Tracker
Although most trackers buy shares in the proportion of their size relative to the index – so called market capitalisation weighting – there is another class of tracker which uses other criteria to decide what shares to buy and in what proportion. These are known as fundamental index trackers and you can learn about them in Fundamental Indexing Can't Save You From Aliens.
You can also buy index trackers using Exchange Traded Funds (ETFs). These are traded like shares on the stockmarket, and are more suitable for large lump sum purchases. Normal index tracker funds lend themselves to drip feeding in small amount.
Also read: Don't Give Index Trackers The Bird
Back to: The Psy-Fi Blog
Passive investing is usually done through an index tracker. An index tracker is a passive stockmarket fund. It’s passive because there are no managers making investment decisions, it's simply following an algorithm to track a designated stockmarket index.
Stockmarket indices are things like the FTSE100 or the S&P500 which contain a whole variety of different companies and are used to judge how well the stockmarket as a whole is doing. Generally the bigger the company the bigger the percentage of the index it is – so if you buy an index tracker you’re buying shares in the same percentage as they make up the index. You will generally be buying a very broad base of shares which gives you what is known as diversification.
If the stockmarket index goes up so does the value of the fund. If it goes down so does the fund.
Index Tracking Advantages
There are a couple of advantages to index trackers:
1. Three quarters of all managed funds do worse than the index in any given year. So you have a 3 in 4 chance of picking one that does worse than an index tracker.
2. Their costs are lower than managed funds because they’re simple to manage. A lot of managed fund underperformance is because of the management fees that need to be paid.
The argument given against using index trackers is that they give you no chance of outperformance compared to active funds. That’s a weak argument – if you’re capable of identifying which active funds will outperform the market you should be capable of investing directly in shares anyway.
Selecting an Index Tracker
There are all sorts of indices and you need to be careful which one you select. The investment industry is now making up indices to track against and some of these offer very little in the way in diversification. So if all want is to invest in the stockmarket you need to look for one tracking a big and standard index.
Once you’ve decided what index to track then all you’re looking for is the Total Expense Ratio (TER) and tracking error rate. The tracking error rate tells you how closely the fund tracks the index. No fund can be an exact replica of the index but the good ones should get pretty close.
The TER is the combination of all the fees that the fund takes as a percentage of the overall fund value. The big US funds can get down to around 0.25% (a quarter of a percentage point) but anything under 0.4% isn’t bad. For similar TERs choose the fund with the lowest tracking error rate.
Different Sorts of Tracker
Although most trackers buy shares in the proportion of their size relative to the index – so called market capitalisation weighting – there is another class of tracker which uses other criteria to decide what shares to buy and in what proportion. These are known as fundamental index trackers and you can learn about them in Fundamental Indexing Can't Save You From Aliens.
You can also buy index trackers using Exchange Traded Funds (ETFs). These are traded like shares on the stockmarket, and are more suitable for large lump sum purchases. Normal index tracker funds lend themselves to drip feeding in small amount.
Also read: Don't Give Index Trackers The Bird
Back to: The Psy-Fi Blog
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