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A cheap and cheerful punt on the stock markets

Tracker funds, or more accurately index tracker funds, are investment flavour of the month. There is a handful of tracker investment trusts, but most trackers are unit trusts. Like all "pooled funds" they invest money for people who have neither the time nor the expertise to select shares to buy and sell themselves.

But conventional unit trusts try to pick stock to outperform the index, with varying degrees of success. Tracker funds by contrast deliberately try to invest in shares that will follow as closely as possible the rise and fall of the indices which measure average market performance.

Some tracker funds do it by buying a stake in every company in the index they follow. Others use a computer to get as close as possible an approximation while actually holding a smaller range of representative shares.

Most tracker funds specialising in the UK stock market try to follow the FT All-share index, which consists of 900 individual shares, but you can choose a fund to track the FT-SE 100-share index if you prefer only blue-chip shares. US tracker funds usually track the Standard & Poor's top 500 shares, while Tokyo tracker funds tend to follow the FTA World Japan index of 483 stocks.

You can now buy tracker funds that match the performance of market sectors. The HSBC Trixie index tracker tracks the index of UK small companies. Or you can buy funds that will track composite indices like the Eurotrack 100 Index, the FTA Continental index of 533 top companies in Continental Europe, or the HSBC Tiger Tracker, which follows eight separate East Asian stock markets, Hong Kong, Singapore, Malaysia, Korea, Thailand, Taiwan, Indonesia and the Philippines. More trackers following emerging markets generally, or Latin America in particular, are in the pipeline.

You might think all this is something of a cop-out, the next best thing to selecting stocks at random with a pin. But the fact is that tracker funds are not just currently flavour of the month in the unit trust industry. They may well be flavour of the year in 1996, not least because several providers, such as Gartmore and Virgin, offer a UK tracker with no initial charges. Legal & General will not make an initial charge on its new tracker fund. HSBC, which claims a quarter of the UK market in tracker funds, plans to abolish its initial charges in the new year, and others are likely to follow.

Tracker funds are cheap to run and it is easy to follow their progress. This is because they do not need an army of expensive analysts to pick the stocks and decide which shares to buy and which to sell and when in order to maximise the performance of the fund.

They also deal less frequently. HSBC's All-share tracker fund, for example, only holds about 450 shares, which also helps to hold down the dealing costs involved.

The main skill in running a tracker fund is in drawing up a list of stocks that mirror the performance of the stock market in which the tracker invests. The computer then does the rest, telling the manager what he needs to buy and sell so that his fund mirrors both rises and falls.

Pension fund managers like trackers because they cannot underperform. Private investors like them because they can follow the performance of their fund quite easily from the movements of the appropriate indices, which are widely quoted in the financial media.

There is another good reason for investing in a tracker fund. In spite of all their expensive analysts and stock-pickers, funds which try to outperform the index have a rather poor record. In the last three years almost three-quarters of UK general unit trust funds have actually failed to beat the All-share index.

Over five and 10 years the failure rate rises to 90 per cent. This is only partly explained by the fact that real life funds deduct management charges from the value of their assets and pay commission on the shares they buy and sell, while the index excludes charges.

Many actively managed funds also specialise in sectors that will be in and out of favour at different stages of the economic cycle. But the short and long-term evidence is damning. It is very difficult to beat the All-share index. Even if charges are deducted from tracker fund performance, UK trackers still tend to beat the active funds, perhaps because they trade less actively and have fewer dealing costs than ordinary unit trusts.

In other markets the record for share selection is rather better. Almost a quarter of specialised funds outperform the US index; almost a half do better than the European, and more than half the Japanese funds do, perhaps because many Japanese shares in the index are difficult and expensive to trade in. But as far as the UK market is concerned investors wanting a good all-round return may well feel more comfortable with a tracker fund, especially if the movement to abolish initial charges becomes the norm. UK and European tracker funds also qualify for tax-free personal equity plans.