Investment choices - Index funds
April 7, 2007Thanks for visiting! If you like what you're reading, you may want to subscribe to my RSS feed.
After I have covered shares and ETFs, the next topic on my list of investment choices is the index fund - or tracker fund as it is more commonly referred to in the UK. The objective of these funds is to track the performance of an index or a specific sector by mirroring their composition. However, just because a fund is tracking a particular index, doesn’t necessarily mean the performance among different funds will be the same, nor does it imply that the fund’s performance will exactly match the index’s growth.
The main reason for these differences is that there are various ways to replicate an index (or sector). With full replication the fund manager buys every stock in the index in proportion to its weight in the index. This works just fine if the underlying stocks are easily available (to buy and sell) and the number of stocks in the index is not too large, since every buying and selling transaction involves fees, which in turn will be charged back to the individual investors, thus driving annual fees up and profits down.
Another method of replication is sampling where the fund manager only buys the largest shares in the index and mimics transactions only on bellwether shares, i.e. leading shares that can be assumed to reflect the performance of a particular sector.
Any replication method will result in tracking errors which reflect the difference between the performance of the index and the fund’s performance. High initial and annual charges widen the gap between the index and the fund, since fees will have to be taken into account when computing the (annual) performance of the fund.
The three most important points to bear in mind when choosing an index fund are:
- Charges: Some funds have annual charges as low as 0.3% which means that most of the fund’s returns will go back into your own pocket (that includes dividend payments for income shares represented in the fund)
- Index: This is a major consideration since the fund’s performance will be very similar to whatever index you choose. Stable economies promise a more reliable long-term growth than emerging market economies. Moreover, the more common an index is the lower are usually the associated charges while more “obscure” benchmarks usually incur higher fees.
- Tracking error: This can only be based on the historical performance of the fund and thus it is generally advisable to stick to funds that have been around for a few years. Firstly, you have historical data available that you can actually base your research on and secondly, they will have had the chance to learn from their experience and thus minimise the possible deviation.
Now that we have covered ETFs and index funds, there’s one large group of funds left: mutual funds. More on this soon…
