The advantages of tracker funds

To illustrate this we asked the managers of last year's five top performing UK All Companies funds for their current cash exposure. The results were:
Fidelity Special Situations (6.3 per cent) GAM UK Diversified (12 per cent ) Gartmore UK Focus (0 per cent) Marlborough UK Equity Growth (27 per cent) Rathbones Special Situations (4.4 per cent)

In a bear market the ability to hold cash - even incidentally - can work to an active fund's advantage. If you hold five per cent in cash when the market falls 20 per cent you gain about 1 per cent in relative performance. When the market rises this effect is reversed.

Taking views on whether or not to be fully invested is a dangerous game for a fund manager. Often most of the returns in the market come from a small period eg during 1999 there were four months when the All Share generated growth of three per cent or more.

If you missed out on these months then your annual return would have been reduced from 24.66 per cent to 4.92 per cent.

Trackers are only for blue chips

Trackers make most sense for investing in large companies. Active managers have a more convincing record in specialist areas, smaller companies and mid caps. This is partly because good research pays higher rewards in less efficient markets.

Another reason is that less liquid stocks require gradual buying strategies. In Europe and Japan, trackers have been less successful. This may be due to the structure of those indices, or it may reflect more inefficiencies in those markets. Either way, active funds seem to have the edge in those markets.

Trackers and risk

It is often stated that trackers are lower risk investments than active funds. Since they cannot take defensive positions this is a questionable proposition.

A further consideration is that as the FTSE All Share and FTSE 100 indices are heavily dominated by their largest shares, the fortunes of trackers are in the hands of a cluster of very large companies. Over 50 per cent of the market capitalisation of the FTSE All Share is accounted for by just four sectors.

Where trackers reduce risk is in the relative risk of underperforming the index, which is not the same thing as the absolute risk to the investor.

Tracking error

Surprisingly, the performance of trackers does vary. The single biggest explanation for tracking errors are differences in charges. Large trackers have proportionally lower fixed costs.

Another source of discrepancies is the tracking methodology. Trackers focusing on a narrow index tend to opt for full replication i.e. they hold every share in the Index.

However, others seek to simulate the index by partial replication or stratified sampling. These are techniques to avoid holding every stock (to do so would raise dealing costs and distort prices in small caps). Usually this involves holding the major stocks but buying only the most influential smaller companies.

A third minor element is human judgment. For example, managers are constrained by rules which prevent them from holding more than 10 per cent in any one stock. When Vodafone briefly represented more than 10 per cent of the Index tracker managers tried different strategies to deal with this.

Recommended trackers

Best Investment's recommendations are based primarily on low costs and availability within fund supermarkets. For UK All Share trackers we recommend Legal & General UK Index within Cofunds and Fidelity Moneybuilder UK Index within FundsNetwork. Both have no iniital charge and a 0.5 per cent annual fee.

For US trackers we recommend Legal & General US Index within Cofunds (nil initial, 0.75 per cent annual) even though it actually tracks the FTSE US Index rather than the S&P 500 Index.

*(all data until 31/1/02, source: Lipper, offer-bid, income reinvested).

• By Jason Hollands Deputy Managing Director, Best Invest