Is it a question of price or performance?

Tracker funds tend to be the cheaper option but managers of active funds say higher fees are justified by better returns.

From unit trusts to investment trusts, there are thousands of investment funds on the market. And they are a diverse bunch, investing in anything from East German shares to UK Government bonds. But one thing they all have in common is a big question mark hanging over their future performance.

From unit trusts to investment trusts, there are thousands of investment funds on the market. And they are a diverse bunch, investing in anything from East German shares to UK Government bonds. But one thing they all have in common is a big question mark hanging over their future performance.

No matter how impressive a unit trust's track record may have been, there are no guarantees that, once you have invested, your returns will be similarly spectacular. The only financial details which are really clear in advance is how much you will be charged.

Most unit trusts will levy an initial charge of anything up to 6 per cent and an annual management charge of up to 2 per cent. These charges can eat into your investment, though you hope the fund's performance will be strong enough to dwarf them.

But there is a cheaper option. Tracker or index funds, which aim to mirror a market index such as the FTSE 100, have some of the lowest charges around. M&G's FTSE All-Share Index Tracker Fund is among the cheapest and has no initial charge and an annual management charge of just 0.3 per cent. Legal & General's UK Index fund also has no upfront charge and an annual charge of 0.5 per cent.

Tracker funds are one of the most cost-effective ways for smaller investors to buy a slice of the stock market. Providers can offer them far more cheaply than actively managed funds - where the manager tries to produce stronger growth than the market index by skilfully picking undervalued stocks - because they simply use a formula to invest. Expensive in-depth research and market analysis is not necessary, nor is it necessary to pay a high-flying fund manager.

Even so, tracker costs do vary widely. Scottish Widows FTSE 100 tracker unit trust has an initial charge of 6 per cent and an annual charge of 1 per cent, according to financial data provider Moneyfacts. Though they all aim to replicate a certain index, some providers use cheaper methods to achieve the same thing.

M&G, for example, opts to simulate the FTSE All-Share index by investing in a sample of 500-600 shares which has the same pattern of industrial sectors as the index, rather than by holding all 798 shares in the index. This cuts dealing costs.

But how do trackers perform? Managers of active funds say their higher fees are justified by enhanced investment performance. They argue - who cares if you pay 2.5 per cent a year in fees if your investment is growing 4 per cent faster than the index?

"It's a great idea - that active fund managers can out-guess the rest of the market," says Andrew Stronach, spokesman for Virgin Direct. "But all the evidence shows there is a tiny minority of fund managers who actually do that and beat the index." According to research by the WM Company, which measures investment fund performance, in the UK all companies sector over the last 10 years only 20 out of 144 actively managed funds beat the index. "The problem for the consumer is can you find that fund that is going to do it?" says Mr Stronach.

The number of tracker funds on the market has risen sharply since the Government unveiled plans to introduce tax-free Individual Savings Accounts (ISAs). Some independent financial advisers, who make their money by helping investors choose between the thousands of investment funds available, were up in arms when the Government launched its CAT standard initiative for ISAs. Only equity ISAs which had low charges would meet the benchmark, which was seen as a Government seal of approval and a powerful marketing tool.

They feared only tracker funds would be able to keep their charges low enough to win the CAT mark, and that as commodity products which were largely interchangeable, investors opting for them would have no need for IFAs.

But in many cases their fears have evaporated. Several tracker funds have been launched for the retail market since the early days and they are not all the same. Some follow a narrow index such as the FTSE 100, others track the broad FTSE All-Share or a European or US index. Some manage to stay closer to the index than others and charges do tend to vary, so people stillneed help in negotiating the tracker market.

And because tracker funds follow the market down just as faithfully as they follow it up, this type of investment is a particularly bad one to buy in a falling market. So as Michael Bakowski of IFAs Chamberlain de Broe points out, IFAs have a role to play in helping investors time their purchase of tracker units.

While trackers undoubtedly have cost advantages, they are not necessarily a substitute for actively managed funds. John Hatherly, head of global analysis for M&G, says trackers can give cheap exposure to certain markets but there is a place for both types of fund in an investment portfolio for a number of reasons.

Corporate bond funds, for example, have to be actively managed because there is no recognised index for this market, he says. And Justin Modray of IFAs Chase de Vere points out that trackers tend to be fairly general, so an investor keen on growth sectors, such as technology or smaller companies, may choose active management for these.

Mr Hatherly is more optimistic than Virgin's spokesman about the average investor's chances of finding an active fund which will beat the index. "It is possible to access funds with significant outperformance" he says, adding that Micropal figures suggest about half of active funds have managed to beat the market.

Of trackers on the market, Mr Modray recommends M&G's FTSE All-Share Index Tracking fund and Legal & General's UK Index fund, for their low charges.

Mr Bakowski recommends two investment trust tracker funds run by Edinburgh Fund Managers - its UK All Share fund and its US Tracker, which follows the S&P 500 index.

For a tracker with a difference, he points to Investec's Wired unit trust. This fund follows a list compiled by Wired magazine's editorial team of companies making use of the technological revolution.

Chase de Vere, 01225 469371;

Virgin Direct, 0345 939393;

M&G, 01245 390390;

Legal & General, 0500 116622;

Chamberlain de Broe, 020- 7584 3300

Independent Partners; request a free guide on NISAs from Hargreaves Lansdown

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