This guide answers some commonly asked questions about tracker funds, shedding light on how they recreate the performance of their chosen index and why there is often such a difference in the returns of the two.

5CPhotos%5CEditorial%5CEducation%5Ctracker_square.jpg /% An index tracker, or tracker fund, aims to recreate the performance of an index as closely as possible through automated means.

While an active manager aims to beat the performance of a given benchmark – for an equity fund usually the stock market it invests in – a passive fund aims to mirror the returns of that index.

This means that if you buy a tracker, you lose the chance to benefit from the manager’s outperformance – or alpha – but you also avoid the risk of massively underperforming the index, which is possible with active management.

How does it recreate the returns of an index?

Trackers have a number of options when it comes to replicating the index, the simplest of which is just to buy the underlying assets.

The HSBC FTSE 100 Index fund, for example, holds stocks in the 100 companies on the index in proportion to their size, buying new entrants to the list and selling those that drop off it.

Changes are only made on a periodic basis to reduce transaction costs, which is one source of the difference between the fund’s performance and that of the index.

However, not all trackers use physical replication – meaning that not all of them buy the underlying assets. Synthetic methods can be used to replicate performance – typically involving the use of derivatives.

Funds that track indices with a larger number of constituents typically use this strategy, at least in part, as the cost of constantly buying and selling the smaller constituents is too large to be worthwhile given their minimal effect on performance.

However, one of the main selling points of tracker funds is their transparency, which is not the case for those that use synthetic replication methods.

How much do they cost?

One of the main reasons why some investors like trackers is because they are cheaper. There is no manager or research team to be paid.

The fee still affects performance, although to a lesser degree than it would on an actively managed fund.

Why are their returns different from those of the index?

Fees detract from performance. Not fully replicating the index is another reason for divergence. Some funds use stock lending which can even mean that they outperform the index if the profits are reinvested.

Stock lending involves the fund house lending the stock it has bought for the tracker in return for interest, which may or may not be used to reduce fees, depending on the policy of the provider.

What are the major drawbacks?

Firstly, you can never achieve more than marginal outperformance of an index. While a lot of funds fail to beat an index over longer time frames, many do.

Secondly, you lose the ability of an active manager to protect against a market that is falling by moving into more stable stocks or assets.