The ultra cheap way to invest in shares

If you haven't yet used up your Stocks & Shares ISA allowance, index-trackers are an easy route into stock market investing.

If you haven't already used up your stocks & shares ISA allowance for this tax year, now is a good time to consider taking out an index-tracker.

How do trackers work?

For one thing index-trackers are pretty easy to understand.

Let's say you invest in a fund which 'tracks' the FTSE 100 index. The index comprises the top 100 UK companies, and your money will be invested in all of them.

In this way, more of your cash will be held in the largest firms - such as BP, Vodafone, HSBC, Royal Dutch Shell and GlaxoSmithKline - as they make up a greater part of the index. So, for example, if BP made up 7% of the index, then 7% of your investment, or thereabouts, would be held in BP shares.

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The idea is that your investment will mirror the performance of the index as closely as possible. So if the FTSE goes up by 5%, the value of your fund will rise by roughly 5%, too. But don't forget the reverse is also true if the FTSE dips.

UK index-trackers allow you to invest in a broad spread of UK companies, particularly if you pick one which tracks the FTSE All-Share Index. The All-Share consists of almost 700 companies by combining the FTSE 100, FTSE 250 and FTSE Small Cap into one index. This provides exposure to large, mid and small cap companies, making your investment more diversified.

Don't forget overseas trackers are also available if you're looking for some global exposure to shares.

Why are trackers worth getting?

Have you ever heard the term 'passive' management? This is exactly how index-tracking funds are managed. There's no actual fund manager responsible for picking stocks to maximise the return for investors. Stock selection is entirely determined by the composition of the index in question.

What's so good about that? Well, most investment funds are run by professional fund managers whose job it is to choose the stocks the fund will invest in. In other words, they are 'actively' managed, rather than 'passively' managed.

But active management doesn't come for free. These funds are normally a lot more expensive than trackers to cover the cost of the manager's expertise.

That said, don't be fooled into thinking because you're paying higher charges, actively managed funds will perform better. Fund managers might aim to beat the market - unlike trackers, which aim to replicate it - but few of them actually achieve this feat. After all, it's easy to make the wrong investment decisions. In fact, historical returns show trackers often outperform actively managed funds over the long-term.

So, with a tracker you have the potential to get a better return at a lower cost. Can't be bad!

Beware of pricey trackers

It's really important you don't pay over the odds for your tracker. Since they all work in much the same way, there's no reason why you should pay significantly more for one fund over another.

Some trackers still charge annual fees of 1% or more. A decade ago this was considered reasonable for an index-tracking strategy, but things change. These days, charges at this level are very expensive, and will drag down the overall return, so make sure you choose one of the cheaper funds above.

What about my ISA allowance?

The good news is, many tracker funds can be held in a tax-free ISA wrapper. This can boost the returns from your investment even more because growth is free from income tax and capital gains tax. And from next week you'll be able to save £10,680 each year in your tracker, tax-free, as the annual ISA limits will be increased.

This is a lovemoney.com classic article, originally published in July 2009 and updated.