Tracker funds and exchange traded funds
Tracker funds and exchange traded funds (ETFs) are investments that aim to mirror the performance of a market index. A market index follows the overall performance of a selection of investments. The FTSE 100 is an example of a market index – it includes the 100 companies with the largest value on the London Stock Exchange.
- When might a tracker or ETF be right for you?
- How index trackers work
- Risk and return
- Access to your money
- Safe and secure?
- Where to get a tracker fund or exchange traded fund
- If things go wrong
When might a tracker or ETF be right for you?
If you don’t understand a financial product, get independent financial advice before you buy.
These may be for you if:
- you want a less expensive way to invest in a particular type of investment, such as shares, bonds or property
- you don’t believe it’s possible to consistently beat the market
- you want to spread your risks within an asset class by investing in a range of different shares (if it’s a share-based fund), bonds (if it’s a bond fund) and so on
- you understand that you might get back less than you invested and you’re comfortable with that
How index trackers work
- These are financial instruments you buy from a fund company that aim to track the performance of an index. ETFs do the same but are listed on a stock exchange and can be bought and sold like shares. Trackers and ETFs are available to track many indices.
- Trackers and ETFs work either by physically buying a basket of investments in the index they’re tracking or by using more complicated investments to mimic the movement in the index.
- Investment decisions are made automatically according to the fund’s rules.
This passive trading makes index trackers cheaper to run than actively managed funds, so many have lower charges.
- With index trackers, you own a share of the overall portfolio – if the value of the assets (shares etc) in the fund rises, the value of your share will rise. If the value of the assets falls, then so will the value of your share.
- Index trackers are a way to spread your risk within an asset class without having to spend a lot of money. Read more about Diversifying – the smart way to save and invest.
Risk and return
- The tracked index can go down as well as up and you may get back less than you invested.
- Because of charges a tracker will usually underperform the index somewhat, and over a long period that underperformance could be more noticeable.
- Before investing, make sure you understand whether the index tracker is physical or synthetic and whether it is a good fit for your goals and risk appetite. A synthetic tracker is an investment that mimics the behaviour of an exchange-traded fund (ETF) through the use of derivatives such as a swap.
- Synthetic tracker funds and ETFs rely on a counterparty underwriting the risk, and so carry the risk of counterparty failure (for example, Lehman Brothers in 2008). There are various controls which aim to reduce this risk.
- Assessing the risks in synthetic tracker funds and ETFs may be difficult.
- Many ETFs are not based in the UK.
Access to your money
- You can sell at any time but the price you get will depend on market conditions on the day.
- ETFs offer minute-to-minute pricing because they trade like a share; so may be more appropriate than tracker funds for investors who trade more frequently.
- However, it is generally better to hold this type of investment for the longer term - you can ride out ups and downs in value and pick your moment to sell.
Tracker funds and ETFs usually have much lower charges than managed funds
Because tracker funds and ETFs have low running costs, charges are usually much lower than for a managed fund.
You may encounter a number of different types of charges.
- Bid-offer spread: Exchange traded funds have both ‘bid’ (buy) and ‘offer’ (sell) prices. The price you get if you’re selling is slightly lower than the price you pay if you’re buying.
- Annual Management Charge (AMC): An annual charge to cover the costs of managing a fund, typically lower with index trackers than with actively managed funds.
- Ongoing charges: The ongoing charges figure includes the AMC as well as some of the other costs associated with investing in a fund. But it doesn’t show you the total cost of your investment (for example, it excludes entrance and exit costs, trading costs and performance fees).
- Commission or flat trading fee: When you buy or sell shares, such as ETF or investment trust shares, the service that processes the trade will charge a fee. You can keep your trading costs down by choosing a low-cost broker.
Safe and secure?
Fund assets are generally held in safekeeping on investors’ behalf by a trustee or depositary.
If an authorised investment firm goes into default, your assets are protected. You continue to own your investment and the fund’s assets are still invested as before.
If your money is mismanaged – for example, the fund manager invests it in something the fund shouldn’t invest in – then the firm would be required to compensate investors. If it did not have enough money and, therefore, went out of business, then the outstanding compensation would be covered by the Financial Services Compensation Scheme (FSCS) up to £50,000 per person.
You cannot claim compensation simply because the value of your investment falls. All investments involve some risk.
An index tracker will lose money if the index it is tracking goes down.
The FSCS applies to financial advice and investment firms, not shares. ETFs bought directly are therefore not covered by the FSCS.
Where to get a tracker fund or exchange traded fund
You can buy tracker funds:
- directly from the fund management company
- through an agent with ties to the fund manager
- through a fund supermarket or discount broker
- through an independent financial adviser or financial planner
- through an online share dealing service or stockbroker
You can find out more about different types of funds on the Investment Management Association website.
You can buy ETFs in the same way you would buy regular company shares on the stock exchange.
If you’re not sure what kind of investment fits your needs, it’s a good idea to talk to an Independent Financial Adviser (IFA).
As of April 2016, all individuals are eligible for a £5,000 tax-free Dividend Allowance. Dividends received by pension funds or received on shares within an ISA will remain tax free and won’t impact your dividend allowance.
There are three dividend tax bands which apply to all dividend income in excess of £5,000 per year:
- 7.5% (basic rate)
- 32.5% (higher rate)
- 38.1% (additional rate)
If your fund has invested in corporate bonds, gilts or cash, it should pay interest, and that interest will be treated differently to dividend income.
As of April 2016 you are entitled to a personal savings allowance. This means you don’t pay tax on the first £1,000 you earn from interest from bank accounts, savings accounts, credit union accounts, building societies, corporate bonds, government bonds and gilts (or the first £500 if you’re a higher rate taxpayer).
Any profit you make when selling your shares or units counts towards your Capital Gains Tax annual exempt amount. Losses can be offset against other gains in the same tax year or carried forward to future years.
Many tracker funds and Exchange Traded Funds can be held in an ISA. In this case, your income and capital gains will be tax-free.
If things go wrong
Most fund managers are regulated by the Financial Conduct Authority. If you’re unhappy with the service you get or you want to make a complaint, read Sort out a money problem or make a complaint.