An Irish Times guide to the world of personal finance

Tracker funds have become one of the hottest financial products of the mid1990s alongside PIPs and PEPs. Everywhere you look the financial services industry is touting yet another new tracker. But are they as sure a bet as some in the industry would have us believe?

The simple answer is that it depends on factors within stock markets and on the sort of risk the investor is prepared to accept.

Tracker funds have two key features. They guarantee to return the original investment to the investor at the end of the investment term - typically between two and five years. They also guarantee to track the relevant investment stock market index, be that the FTSE 100, the Nasdaq, the Irish Stock Exchange's ISEQ or whatever.

There are several advantages to such a fund:

Simplicity: in guaranteeing simply to match a given index's growth, the fund is understandable to even the novice stock market investor;

Cost: because most of the work on a tracker fund is done by a computer tracking the fluctuations of the stocks within the given index, the cost of tracker funds is a fraction of that of its managed equivalent. Entry and exit costs are minimal where they exist at all - compared with entry rates of up around 5 or 6 per cent on some managed funds - and the annual management fees themselves are generally half or less those of managed funds.

Risk: tracker funds give the investor the chance to accumulate substantial capital growth over a number of years with the underlying guarantee of the return of their stake even in a worst-case scenario. With the fund mirroring the relevant index, the risk element of the investment is lowered.

There is also the option of choosing a tracker as a unit trust or a tax-efficient PEP.

Basically investors are betting that the computer can produce a better result than the financial institution's stock market experts. And, in recent years they have been right.

A lot of this has to do with the nature of the bull market in recent years. In a rising market, tracker funds are always going to look good. In a market where this rise has been strongly and consistently led by a small group of stocks such as has happened this time around with the leading banks in Ireland, the tracker fund has an advantage as it faithfully reflects the strength of the relevant parts of the index.

Further, it only has to match the index; the managed fund is expected to beat the index - that is the expertise for which the investor pays higher charges.

The managed fund, though, comes into its own in the more normal market conditions which may yet prevail over the coming year or so. That is where they invest in a range of shares - generally smaller and medium-sized companies and especially those which have under-performed in the recent past.

There are two reasons why the return from a tracker fund might not match the index to which it is supposedly tied. Firstly there is the issue of any entry and management charges, however low. These will naturally reduce the performance of the tracker and, if it faithfully matches the relevant index, produce a marginally below-par return.

More common is the situation where, rather than buy all the stock in a given index in precise proportion to their strength in that index, the fund manager chooses to buy what he considers a representative sub-section whose performance over time has been shown to match the index as a whole. This is especially common in larger indices, such as the FTSE All-share which includes 900 stocks.

Scarcity of some stock may also be a reason for compensating with other shares to reflect the full performance of the index. This occurs more in smaller indices such as the ISEQ, where some of the issues are tightly controlled by a small number of shareholders.

At the end of the day, the tracker is a good vehicle to mimic the index, within reason, but unlikely to beat it.

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