Six great reasons to choose an index tracker

If you're dipping your toe into the stock market waters for the first time, index trackers are a great place to start.

If you’ve got a little spare cash, and want a better return than an ordinary savings account can generate, stock market investing may be on your radar. But if you’re pretty new to the stock picking game, how do you know which shares to buy?

Luckily, if you’d rather not spend endless hours picking your own stocks, you don’t have to with a simple investment strategy known as index tracking. Here are six great reasons why index tracking could be perfect for you:

1. They’re easy to understand

An index tracking fund replicates - or ‘tracks’ - the performance of an index by investing in all the shares quoted on it. For example, a FTSE 100 index tracker will invest in every one of the top 100 UK companies.

This means if the FTSE 100 rises by 5%, the value of your investment will increase accordingly (with a deduction for fund charges and a tracking error - which represents how closely the fund matches changes in the index). Equally, if the FTSE 100 drops by 5%, your investment will drop by roughly the same amount.

It’s as simple as that. All you need to do is decide which index you would like to track. For example, you can stick to the home market if you wish. If you want an investment that covers the majority of UK listed companies, choose a FTSE All Share tracker - rather than one based on the FTSE 100 - and you’ll gain exposure to around 98% of the market. It’s also possible to invest in trackers globally which replicate indices overseas.

2. They’re cheap

Index trackers are ‘passively managed’ which means there’s no fund manager actively picking stocks to invest in, as this decision is completely determined by the companies that come onto the index, or fall off it. There are different ways of tracking, but commonly the amount invested in each company will equate to the proportion of the index it comprises. In other words, the most money will be invested into the largest companies.

Because there's no active fund manager - the index tracking strategy can be achieved by computer - the fund charges are significantly lower with no investment expertise required. In fact, the cheapest trackers available to the UK investor take an annual management charge of just 0.15%. This is the charge applicable to the FTSE UK Equity Index fund from Vanguard Investments. In fact, there's a whole raft of tracker funds which charge 0.5% or less.

Remember, any index tracker with a significantly higher charge is effectively ripping you off since all trackers which invest in the same index are essentially doing the same thing. A fund with annual charges of 1% should be considered very expensive.

3. They’re affordable

Index trackers are also great for smaller investors since many funds require a relatively low monthly contribution from you. If you’ve got say, £50 a month available, you should find plenty of trackers which will accept this level of investment. Of course, trackers will be able to accept payments from larger investors too.

4. They beat many actively managed funds

You might think a passively managed fund couldn’t possibly perform as well as a fund with an active fund manager. But you’d be wrong. Picking the right stocks is an incredibly difficult task, and even the experts make the wrong calls on a regular basis.

In fact, index tracking funds have been shown to regularly outperform managed funds. But, don’t forget, you can only expect returns which closely match how the stock market is doing as a whole. A handful of the top performing funds are capable of beating the market, but you will have to pay higher charges for the benefit of the manager’s stock picking prowess. 

You should also bear in mind that the top funds today may not continue to be the star funds of tomorrow. But, with an index tracker, you’ll have an investment which always generates returns more or less in line with the market.

5. They can be invested tax-efficiently

You can boost the returns from your tracker fund even more by holding it within a pension or ISA wrapper. That way, your investment will grow completely free of both income and capital gains tax. These days you can save as much as you’d like into a pension to plan for your retirement (with restrictions in place for higher earners). Meanwhile, under current rules, you can invest a maximum of £10,200 into a stocks and shares ISA each year. This is going up to £10,680 from 6 April.

If you wish, you can hold a tracker alongside other investment funds to diversify your pension or ISA portfolio. Index trackers can also be held as direct investments outside pensions and ISAs, but then any capital growth earned will be taxable when you take a profit.

6. They won’t take up your time

Finally, as you’ve probably realised by now, you don’t need to be an investment whizz to pick a decent index tracker. Nor do you need to spend your precious time seeing how particular sectors or shares are performing before diving in. All this is done for you, making trackers the perfect choice for novice investors.  

This is a classic article that has been updated for 2011.

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