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?
If you don’t understand a financial product, get independent financial advice before you buy.
Exchange Traded Funds (ETFs) and tracker funds are both passive investments that aim to replicate the movement of an index and to deliver a return in line with the index they are tracking.
These might 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.8
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 might 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 might 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 might 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 might 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.
On-going charges figure (OCF)/ Total Expense Ratio (TER): The OCF figure previously known as the TER (which is broadly similar to the OCF figure) gives an indication of the cost of investing in a manager’s fund. The OCF includes most of the fees and charges incurred by the fund including the annual management charge, registration fee, custody fees and any distribution costs but excludes One-Off Charges (e.g. entry, exit or switching charges), Incidental Costs (e.g. performance fees) and Portfolio Transaction Costs (the costs of buying or selling assets for the fund). The OCF figure provides a useful way standard way of measuring the annual cost of investing in a fund and is based on the previous year’s financial expenses.
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 depository.
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 if it failed after 1 Jan 2010 but before 31 Mar 2019.
If the firm failed after 1 Apr 2019 then you may be covered if the firm gave misleading advice, provided poor investment management or mis-represented the firm which gave you the initial advice which has since failed up to £85,000 per person or firm. The FSCS applies to financial advice and investment firms, not shares. ETFs bought directly are therefore not covered by the FSCS.
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.
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 online share dealing service or stockbroker
- through an independent financial adviser or financial planner.
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).
Tax on interest and Dividend Payments
Interest distributions from UK domiciled funds are paid gross. This means no tax has been deducted from the payment. If you own shares, you might get income in the form of dividends. Dividends are a portion of the profits made by the company that issued the shares you’ve invested in. Dividends from UK domiciled funds are also pad gross.
In April 2018, a new tax-free Dividend Allowance of £2,000 a year was introduced for all taxpayers. Dividends that fall within your Personal Allowance do not count towards your dividend allowance. Dividends above this level are taxed at:
- 7.5% (for basic rate taxpayers)
- 32.5% (for higher rate taxpayers)
- 38.1% (for additional rate taxpayers).
You do not need to tell HMRC if your dividends are within your dividend allowance for the tax year. If you need to pay tax, how you pay depends on the amount of dividend income you got in the tax year.
Capital Gains Tax
When you cash in your shares or switch between funds you may incur a liability to Capital Gains Tax. This might be payable if you sell your investment and make a profit.
Capital Gains Tax is a tax on the profit when you sell (or ‘dispose of’) something (an ‘asset’) that’s increased in value. It’s the gain you make that’s taxed, not the amount of money you receive. The capital gains tax allowance (CGT) in 2019-20 is £12,000.
The capital gains tax allowance is the amount of profit you can before CGT is payable. The CGT rate for assets is currently 10% if you’re a basic rate taxpayer and 20% if you’re are a higher or additional rate tax payer.
If you are married or in a civil partnership, you are free to transfer assets to each other without any CGT being charged.
Losses can be offset against other gains in the same tax year or carried forward to future years.
Fund domicile and reporting status of ETF’s
Many ETFs are domiciled in other countries. It is advisable to check the reporting or distributor status of these funds to ensure you are taxed appropriately. Overseas-domiciled ETFs without a reporting status could be subject to alternative taxation. This could be much higher as it’s taxed as income.
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.
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