The great debate

Should you opt for index-trackers or actively-managed funds? It all depends which financial expert you are talking to

Index-tracking funds were a big hit with PEP and ISA investors towards the end of the 1990s, offering the winning combination of low charges and strong performance. But over the last 12 months performance has slipped, and many financial experts now claim their halo has slipped. Should you still put your faith in them?

Index-tracking funds were a big hit with PEP and ISA investors towards the end of the 1990s, offering the winning combination of low charges and strong performance. But over the last 12 months performance has slipped, and many financial experts now claim their halo has slipped. Should you still put your faith in them?

Trackers dispense with the battery of managers, researchers and analysts employed by most traditional investment funds to pick stocks and actively manage the fund. Instead they aim to replicate movements in their chosen index as closely as possible, by passively following it up or down. This makes trackers cheap to run and inexpensive to buy.

Most, but not all, trackers have no initial charge when you pay your money in, and a minimal annual charge, which falls to as low as 0.29 per cent on the Liontrust Top 100 fund. By contrast, active funds have initial charges of anything up to 5.25 per cent and annual fees of up to 1.75 per cent.

Many investors are unaware of the damage charges can do to the performance of their investment fund. The average initial charge on an actively-managed fund is 3.94 per cent, says Virginmoney.com research. This means investing £1,000 will typically pay £39.40, which may not sound much but adds up over time. Invested in the FTSE All-Share Index in January 1980, this sum would be worth £1,047 today. Virgin's figures also show investors in high-charging funds must wait on average more than four months before their money has grown enough to overcome initial charges.

Index-tracking funds began to look unbeatable when performance figures emerged several years ago, showing they beat 80 per cent of active fund managers. "Trackers take much of the risk out of investing. They give a broad spread of shares and a steadier investment return than actively-managed funds," says Gordon Maw, Virgin's marketing manager. "They eliminate human error. While some managers outperform one year, the following year they may struggle. Trackers give you consistency, so you don't need to worry about a manager losing their touch."

Mr Maw says that tracker performance has recently slumped, but dismisses this as a "blip", and says when markets start to rise again their inherent advantages mean they will again prove a good bet.

While tracker funds generally maintain a charging advantage over actively-managed funds, don't assume all can be bought at minimal cost. The Barclays FTSE 100 tracker has an initial charge of 5 per cent, higher than most active funds. Specialist technology tracker Investec Wired Index Trust also has a 5 per cent initial charge, plus a 1.25 per cent annual charge.

Even among funds with no initial charges, annual charges can vary. Virgin UK Index Tracking is at the higher end charging 1 per cent, compared to 0.5 per with Legal & General UK Index and 0.3 per cent with M & G Index Tracker.

Even small differences in charges can make a difference to your investment return. Virgin returned 11.7 per cent over the last three years, compared to 13.66 per cent from M & G, say Micropal figures.

Oddly, many trackers also fail to match the performance of their chosen index, says David Aaron, chief executive of financial advisers David Aaron Partnership. He says the best-performing All-Share index tracker over the last five years was Dresdner RCM UK Index, which has no initial charges and a 0.5 per cent annual management charge, and returned 87.4 per cent, compared to a rise of 87.9 per cent in the overall All-Share index. But Old Mutual UK All-Share Mirror Fund, which has no initial charges and 0.75 per cent annual charge, returned just 71.5 per cent.

"The average All-Share tracker fund performed 7.7 per cent worse than the index. Tracker funds linked to the FTSE 100 Index fared even worst. The best fund over five years, Marks and Spencer's UK 100 Trust, rose 83.3 per cent, yet the index rose 94.7 per cent. The average FTSE 100 tracker underperformed by 8.2 per cent. This is because no tracker replicates their stock market index exactly," he says.

Mr Aaron adds that many actively-managed funds also underperform,but offer scope for some tremendous outperformance - the top actively-managed fund, Solus UK Special Situations, rose 320 per cent over the last five years.

"There are some excellent fund managers who have outperform tracker funds by substantial margins, and I believe they will continue to outperform in the future," says Mr Aaron.

Martyn Page, head of research at Countrywide Independent Advisers, says both active and tracker funds are likely to enjoy periods when they are top dog.

He says the advantage of tracker funds is that you know what you are getting. "Trackers are not erratic, most do what they set out to do, and will perform best when markets are driven by large blue-chip companies. Their low charges give you a head start over actively-managed funds."

They also remove the uncertainty over what will happen to investment performance if the manager of an active fund leaves. "What if you back a star manager, then one year later he leaves to run a hedge fund? You might then decide to switch to a new fund, but will incur costs as a result."

Another drawback with active funds is that investment houses are prone to merge or rationalise funds, he says, which could change the nature of the investment you hold.

Tracker funds do not just follow the major UK indices. You can also buy trackers covering the US, Europe and Japan, as well as themes such as global investment, and sectors such as technology, health and pharmaceuticals.

"Trackers tend to work best in efficient markets such as the UK and US, where sufficient information is available to allow them to track company performance. They do not do so well in Europe and the Far East, where managers find it easier to add value."

Mr Page says charges are the most important factor when choosing a tracker. He recommends Legal & General UK Index, which has a 0.5 per cent annual fee, and M & G Index Tracker and Royal & SunAlliance FTSE All-Share Tracker, which both have annual fees of 0.3 per cent.

David Aaron Partnership 01908 281544

Investec Wired Index 0207 597 1800

Legal & General 0800 0920092

Liontrust 0207 412 1700

M & G Group 0800 210223

Royal & SunAlliance 0870 601 6183

Solus UK Special Situations 0161 2146500

Virgin Direct 08456 101010 or www.virginmoney.com