Danger up ahead for trackers?

The Government plans to make index-tracker funds central to its new savings plans. But, as Paul Slade discovers, some experts fear that a stock market dominated by trackers could give all investors a bumpy ride

Index-tracking trusts have proved enormously popular with investors, and can point to an impressive track record over the past few years.

Small savers like the simplicity and low charges of unit trusts which - rather than relying on a fund manager's judgement - merely select stocks to duplicate the performance of their chosen stock-market index.

Helen Liddell, Economic Secretary to the Treasury, evidently agrees. She has suggested that only Individual Savings Accounts based on an index- tracker trust should qualify for the Government's proposed CAT (Charges/Access/ Terms) mark of approval. Leaks suggest the proposed stakeholder pension will be built on index-trackers, too.

However, Roger Cornick, deputy chairman at Perpetual, a leading fund management group, says: "If you get two mainstream investments [stakeholder pensions and ISAs] going into the stock market through index-tracking funds, it is clearly going to represent the huge majority of private investment in shares."

But there is a paradox here. Index-trackers, by definition, aim to duplicate the performance of a much wider market which is driven by actively managed funds. Sceptics argue that, if too much money goes into trackers, they will artificially inflate the value of the biggest companies' shares and make the whole market more volatile.

Matthew Orr, a partner at stockbrokers Killik & Co, says: "The ultimate extension of the tracker argument is that everybody goes in a tracker. You end up with one judgmental investor left, and he can push the market whichever way he wants, because he's the only one with a view. It's going to put the power of market movement into a diminishing number of hands, which could lead to volatility."

Amanda Davidson, a partner at Lindon-based independent financial advisers Holden Meehan, believes some of the violent swings in the Dow Jones share index are partly caused by the longer-established use of trackers in the American stock market.

She says: "There is certainly a link between how much is kept in trackers in the States and the volatility in that market. The US really is quite volatile considering that it's an established market, and that's because you've got too much in trackers there."

Richard Wascoat, director at Fidelity Investments European, adds: "The sheer weight of money ploughing into the index funds pushes up stocks, and throws economic fundamentals out of the window. It can carry on for a while, but not forever."

Justin Urquhart Stewart, a director at Barclays Stockbrokers, suggests the FT-SE's growth is already being driven partly by increased demand for the limited number of shares available in the biggest companies - a trend which more tracker investment would magnify.

He says: "What trackers end up doing is skewing all the money towards a limited supply of stock. That will continue to happen, but it doesn't mean the FT-SE will defy gravity."

But Martin Campbell, Virgin Direct product development manager, whose company has attracted more than pounds 1.5bn into index-tracking funds since its launch in 1995, rejects these fears. He says less than 1 per cent of money in the FT-SE All-share index is in tracker funds today.

Mr Campbell says: "Even if everybody who takes out an ISA tracks the index and everyone who takes out a stakeholder pension tracks the index, it may well be that it never even has an influence, let alone becomes any kind of dominating thing."

Even if there is a flood of cash into trackers, Ian Millward of independent PEP advisers Chase de Vere believes the very best actively managed funds will better their performance.

He says: "As soon as everyone goes into trackers, there's no research done, and the market becomes hugely inefficient. It's then that there are tremendous opportunities for active fund managers to out-perform. The whole idea that trackers can be the solution is completely flawed before it starts.

"Once all the money goes into trackers, all of a sudden active's the place to be."

Mr Campbell has an answer for this, too. "If you put all the active guys in a huge pot, and look at what the net impact is, they are practically tracking the market anyway," he says.

WHICH INDEX TO CHOOSE?

Savers must not only choose between a tracker fund and an actively managed one, but also think which stock-market index they want to track.

Most trackers use either the FT-SE 100, which lists the UK's 100 biggest companies, or the All-share, which lists 855 shares - including some much smaller ones. Many fund managers believe that, after a long period of under-performance, smaller companies now offer the best value.

As the table left shows, the UK's 10 biggest trackers have a total of pounds 3.9bn under management. Of this total, pounds 2.4bn (59.4 per cent) goes into the All-share, and the remainder into the FT-SE 100.

Some trackers use full replication, which means they buy a stake in every company. Others take a smaller sample, selected to represent the whole index.

Virgin Direct's Martin Campbell says: "It's important to have a spread across smaller companies as well, and that's why we think full replication of the All-share index is what the Government should set out as a CAT mark standard."