Personal Finance: Do not let trackers drive you crackers

Careful research is needed if you want to profit from the low- fee world of index funds.

Why pay more when you don't need to? The argument, which applies just as much to a loaf of bread as it does to investments, has never seemed more relevant than in the world of so-called "tracker" funds.

The argument in favour of trackers, which aim to replicate as closely as possible the performance of a chosen share index, usually either the Footsie 100 or the FT All Share, is simple: their fees are lower and their performance better than most active UK equity unit trusts.

A study by Standard and Poor's Micropal shows that the average return for funds tracking the Footsie 100 has been 75.74 per cent in the three years to 5 April, compared with just over 50 per cent for actively managed funds in the UK Equity Growth sector.

Of course that doesn't mean that investors should always chose index funds over actively managed funds. The best active fund managers will always beat index trackers. However, investors who are not convinced of their ability to choose the top future fund managers, but believe that the market will continue its upward trend, should have exposure to tracker funds.

Tracker funds fall under three categories: those that replicate the index by buying every stock in proportion to its size in the market; those that "sample" the index by selecting a number of stocks that, when combined, have the risk characteristics of the wider share index, through a process called optimisation; and those that sample the index through "stratification", where they invest in the larger stocks and a random sample of small and mid-cap stocks.

Even though all tracker funds aim to replicate a particular index, investors will find that performance between them can vary significantly. This is because all funds will have "tracking errors", or variations from the index, which will affect performance.

Because investment decisions are made by computers rather than highly paid managers and analysts, the fees are much lower than for active funds. However, there is still quite a bit of variation in fees. What impact do they have on performance?

Standard & Poor's Micropal shows there are 33 index tracking funds with a minimum investment of no more than pounds 3,000. Annual management fees vary between 0.35 per cent a year for River & Mercantile Top 100 and 1 per cent for a group of 17 funds, which include Barclays' own fund, HSBC, Virgin and Marks & Spencer. Some trackers levy initial charges of up to 6 per cent.

If you invested pounds 1,000 for 10 years and the market grew at 7.5 per cent per annum, at the end of the period your investment could be worth as much as pounds 1,995 if you invested with the company charging t0.35 per cent or as little as pounds 1,765 if you invested with the company charging 1 per cent as well as an initial fee of 6 per cent.

Although the initial fees have a sizeable impact on performance, especially if the investment is held for only a few years, over the long term the level of the initial fee is less important than the management fee.

For example, if you held a fund with a 0.35 per cent management fee and an initial charge of 6 per cent for 20 years, you could expect your investment to be worth pounds 3,741, assuming the underlying investment grew at 7.5 per cent every year.

If, however, you invested in a fund charging a 1 per cent management fee but no initial fee, your investment would be worth only pounds 3,524, pounds 217 less than the fund with the initial charge.

The initial fee therefore should be a big consideration when choosing a fund for the short term but less so if the fund is expected to be held for the long term.

In any case, if you do choose a fund with an initial charge, it may profit you to call the fund managers directly as they may be able to reduce or even to eliminate the initial charge completely if you don't use an intermediary.

Jonathan Harbottle, the marketing director at River & Mercantile, a firm which does not levy an initial charge and has the lowest management fee, explains: "We offer a low cost product because our overheads are low.

"We have managed to reduce the cost of running this fund by outsourcing to Barclays Global Investors who manage over pounds 30bn in UK tracker funds.

"For them, the additional cost of managing this pounds 70m fund is not sizeable, and we have passed the savings on to our investors. Furthermore, it is cheaper to get full replication of the FTSE100 index than the All Share since you are only dealing in the 100 most liquid companies."

Another low fee charger, City Financial NetPEP Tracker, also outsources to Barclays Global Investors. It too charges 0.35 per cent.

Interestingly, Barclays' own index fund, Barclays FTSE 100 Fund, charges a 1 per cent management fee, which is significantly more. Robert Jenkins, the head of public relations at Barclays Global Investors, says: "We can't comment on what fees are being charged because this is decided by the retailer, which in this case is Barclays Bank."

More important than the fees, however, when deciding on an index fund is which index you are going to track.

If you'd chosen to invest in the FTSE 100 for the past three years, rather than the FT All Share, then your investment would have risen by 82.31 per cent versus 66.96 per cent. This dwarfs any differential due to the fee structure.

If you believe that large liquid companies are going to drive the market then choose Footsie 100 trackers. However, if on the other hand you believe that small and mid caps have lagged for long enough, then choose a fund that tracks the FT All Share.