Can a tracker take a wrong turn?

Marketed as low cost and low risk, these funds can suffer for slavishly following an index, warns Sam Dunn

Tracker funds, which mirror the performance of a basket of shares, have long been considered low-risk investments.

Their raison d'être - to follow a stock market index such as the FTSE 100, slavishly reproducing its movements up or down - appeals in particular to those who are dipping a toe into the market for the first time and wish to avoid racier investments.

Since there is no need for them to employ a fund manager, trackers tend to have low charges - usually nothing to pay up front and an annual charge of no more than 1 per cent. And there's no risk of all your money disappearing when a manager's punt on an individual stock goes disastrously wrong.

Yet concern is growing that investors are buying tracker funds without realising that their performance relies on only a handful of stocks. Since a company's market capitalisation determines its weighting in an index, a tracker ends up investing the bulk of its money in the biggest stocks. Your risk is not evenly spread across the index.

The top 20 companies in the FTSE 100 make up more than half of the index. "A lot of people don't realise that they have such commitment to so few stocks," warns Phil Wagstaff, managing director for UK retail funds at M&G. "Even [with] the FTSE All Share, 45 per cent [of the weighting] goes into the top 20 companies out of some 640 stocks, so a large element of the performance will be driven by these stocks."

If the big boys don't perform, the tracker flounders. In the FTSE 100's case, where oil giant BP makes up nearly one tenth of the index, trackers are investing heavily in an individual stock.

Gavin Haynes, investment director at independent financial adviser (IFA) Whitechurch Securities, says: "Some people think you're buying an even spread of all the companies listed in the stock market, but really you are relying on the top companies. There is a danger that you are exposed to a stock-specific risk."

The popularity of trackers has waned in the past three and a half years as markets have fallen. Figures from the Investment Management Association show that £2.6bn was invested in tracker funds from July 2002 until the end of June 2003, representing a 16 per cent slump on the previous year. During that period, the average tracker fund in the UK All Companies investment sector fell by 8.84 per cent, according to the fund- rating agency Lipper.

Trefor Owen-Jones, director at IFA Buckles, says trackers have had a "quiet time" recently but believes they have been sold as low risk for too long. "They should be considered as no more than 20 per cent of a portfolio. We consider them as a medium risk because it's a case of saying half of your investment is, in effect, in 10 stocks."

So is it worth paying more in management costs to benefit from the skills of a fund manager? Although specialist funds come with higher risks as well as charges, they have outperformed trackers. In the year ending 30 June, New Star's Select Opportunities fund rose by 3.48 per cent and Invesco Perpetual's UK Aggressive fund by 14.19 per cent.

Philippa Gee, investment director at IFA Torquil Clark, says: "There is a case for paying more for charges as there are some very good actively managed funds out there, such as the Gartmore UK Focus Fund run by Ashley Willing.

"Trackers are an uninspiring investment but, at the same time, if you have invested in a really zippy fund, then a boring, mainstream fund [to go with it] is perfectly acceptable."

If you feel a tracker would balance your investment portfolio, shop around for one. Not all trackers are cheap: Govett's FTSE 250 Index tracker carries a 3.5 per cent initial charge as well as a 1 per cent annual management charge (AMC).

Watch out for custodian and registrar fees, which make up part of the total annual cost. For example, M&G's All-Share tracker has no initial charge, an AMC of 0.3 per cent, and custodian and registrar fees of 0.17 per cent.

Make sure you get as much diversification as possible: M&G's Mr Wagstaff points out that a FTSE All Share tracker provides greater diversification than a FTSE 100 tracker. But check how closely it tracks the index; aim for a margin of error of 1 per cent or less.

It's also worth checking that the actively managed funds you are invested in are not closet "index huggers" where the manager barely deviates from an index. If so, you could have paid an initial charge of as much as 5 per cent for nothing; and the annual charge is also likely to be higher than the 1 per cent typically levied by trackers.

For those who want an alternative to a tracker, Whitechurch's Mr Haynes suggests actively managed funds such as Cazenove's UK Growth and Income or Liontrust's First Large Cap.