Tracker funds (also known as index funds or passive funds) aim to track the performance of a particular index, such as the FTSE 100 or S&P 500. The funds may hold all, or a representative sample, of the stocks in the underlying index (physical replication), or replicate the performance of the index via buying derivatives (synthetic replication).
The aim is to have as low a tracking difference (the gap between the performance of the index and the fund) as possible. Since the goal of a tracker is to match the index, significant outperformance is as concerning as significant underperformance (even if it might not feel like that to an investor), because it suggests problems with the way the fund is being run.
Tracker funds can be traditional open-ended funds (unit trusts or open-ended investment companies [Oeics]) or exchange-traded funds (ETFs) listed on a stock exchange. Investment trusts are almost never used as tracker funds because – unlike ETFs – they have no mechanism to keep the fund’s share price in line with the value of its assets.
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The first tracker open to ordinary investors was the Vanguard Index fund, which launched in the US in 1975. Rivals were sceptical as to whether it would ever succeed, arguing that people wouldn’t be satisfied with merely matching the market, but the concept caught on.
The big advantage of passive investing is cost: a FTSE 100 tracker fund can have an annual charge of well under 0.1% a year. An actively managed fund could easily charge ten times as much, with no guarantee it will beat the index (most don’t over time). A closet tracker is an active fund that sticks close to its benchmark index to avoid under-performing the market too drastically (and thus losing clients). Investors in a closet tracker are being charged the higher fees of active management in exchange for passive performance or worse.
