The Secret To Successful Investing

The good, old index tracker fund is a long-standing Foolish favourite. But are they all the same?

Regular readers of the Fool will know how fond we are of index tracker funds. As a simple, low-cost way of investing in the stock market, we reckon you can't go far wrong. If this is a new one on you, let me explain - an index tracker fund is essentially a share-based investment which invests in all the companies quoted on a particular share index. In theory, the fund should then mirror - or track - the peformance of the index. Or to put it another way, if you invest in a FTSE 100 tracker, your money will be invested in all the top 100 UK companies and if these companies do well your investment will rise in value too. But why do we like trackers so much? Well, these funds often perform better over the long-term than many funds which are managed by professional fund managers. A manager is responsible for making strategic stock selections with the aim of outperforming the market. Trouble is, that's a pretty difficult task and many don't achieve it. Trackers, on the other hand, simply replicate an index of shares as closely as possible and this is often a more successful investment strategy than attempting to outdo the market. Even better, trackers are a lot cheaper. Many of the best trackers will cost you less than 1% in charges. Actively managed funds often charge initial fees of around 5% with annual charges of 1% to 1.5% on top. While we give trackers the thumbs-up overall, some funds still perform better than others so which one should you choose? How well a tracker does is largely influenced by the index it tracks. Have a look at the table below to see how they compare: Best Five UK Trackers Versus Worst Five UK Trackers Over 5 Years (£1,000 investment) Best Five Tracker Funds 5 Year Performance To 01.01.08 Rank Index Tracked Total Expense Ratio (TER) HSBC FTSE 250 Index £2,584 1 FTSE 250 0.87% Scottish Widows UK All Share Tracker £2,032 2 FTSE All-Share 0.34% Fidelity Moneybuilder UK Index £1,982 3 FTSE All-Share 0.28% F&C FTSE All-Share Tracker £1,981 4 FTSE All-Share 0.34% Allianz RCM UK Index £1,976 5 FTSE All-Share 0.61% Worst Five Tracker Funds St James Place Tracker £1,819 28 FTSE All-Share 1.45% Gartmore UK Tracker £1,803 29 FTSE 100 1.25% Halifax UK FTSE 100 Index Tracker £1,775 30 FTSE 100 1.50% Clerical Medical FTSE 100 Tracker £1,756 31 FTSE 100 1.00% Legal & General A&L UK 100 Tracker £1,745 32 FTSE 100 1.37% Source: Past performance data - Investment, Life & Pensions Moneyfacts. Total expense ratio data - Investment Management Association. If you invested £1,000 into the HSBC FTSE 250 Index fund your money would be worth £2,584 by the 1st January. I think that's a pretty impressive return over five years. But if you chose the Legal & General A&L UK 100 tracker fund instead, you would only end up with £1,745 over the same period. That's over £800 less. But why is there such a difference between funds performance? If you buy a FTSE 100 tracker you'll be investing in the 100 largest blue chip companies. Many of these companies are international giving the index global exposure. But the FTSE 100 can be unbalanced as an investment. Around 40% of the index is made up of banking and financial shares. If that sector is struggling it will pull down the value of the fund because the manager isn't able to sell-up. Of course, the reverse is also true. The FTSE 250 Index is much more UK focused and is made up of the next 250 largest companies after the FTSE 100. This means you will hold an entirely different set of shares than you would with a FTSE 100 tracker. Four of the best five funds are FTSE All-Share trackers. This index currently consists of 683 companies and combines the FTSE 100, FTSE 250 and FTSE Small Cap Indices. It represents around 98% of the UK stock market and blends large, mid and small cap companies making it far more diversified. While it's easy to see why trackers which follow different indices don't produce the same returns, you would expect those which track the same one to perform in exactly the same way, right? But this isn't the case. For one thing, higher charges will drag performance down. The cheapest tracker is the Fidelity Moneybuilder UK Index fund with a total expense ratio (TER) of just 0.28% - the TER covers all the charges you'll have to pay. But, the Halifax UK FTSE 100 Index Tracker is far more expensive with a TER of 1.50%. There can also be a discrepancy in performance because of the `tracking error' which measures how closely a fund matches the index. It's impossible to replicate an index exactly although some funds may be more precise than others which can account for some of the difference in returns. When it comes to choosing a tracker I reckon a competitive FTSE All Share tracker is a good bet because of its diversification which tends to do better than the more concentrated FTSE 100. But make sure you don't pay over the odds for it - a TER of more than 1% is expensive in my book. And don't forget, trackers are often available in ISAs so you could benefit from a tax-free return too. More: Take a closer look at index tracker ISA funds at The Motley Fool's ISA centre.