The investment objective of a tracker fund is to 'track' the performance of a specific stock market index or sector as closely as possible. It does this by holding the same equities in the same amount as the index it tracks or in a representative sample.
Thereby, trackers invest in shares that make up the index and try to track it exactly. You may get tiny fluctuations since it is very difficult for the funds to exactly match the index every day as shares go up and down and become a bigger or smaller component of the index.
A tracker fund is 'passively' managed, meaning the fund manager makes no decisions about what companies to invest in: shares are only bought or sold when the index changes i.e. index trackers are designed to follow the performance of a specific benchmark. Index trackers aren't intended to outperform (or underperform) the market although the results can vary from provider to provider since some trackers buy shares in all the index constituents while others limit themselves to buying a number of companies in the index. An active fund manager, on the other hand, selects individual stocks to buy from a wide range of sectors. The tracker route makes the fund manager's job pretty easy and highlights one of the major differences between the two types of funds which is cost
There are two ways of investing in a tracker:
The first is to use your cash to buy one of the index tracker funds offered by the various fund management and insurance companies.
You can buy into these funds by contacting a discount IFA/broker which will rebate any fees and charges. You may wish also to put this fund into an ISA tax wrapper to avoid tax.
The other way is to set up a brokerage account (many are free) and buy an "I-share" or Exchange Traded Fund, which is a tracker in the form of a share. These have lower charges, and you trade them like normal company shares, except there is no stamp duty (another tax). You can check their progress online. You can also put them in an ISA.
A tracker fund or share "tracks" the index. This means that the shares it holds are weighted according to the size of the listed companies. If you look at the FTSE All Share, the biggest companies are banks and oil/mining companies, so a lot of your money will be invested in those stocks. Some people (including me) think that tracker funds are riskier than generally thought for that reason.
The big thing to watch out for is charges - they can eat up a big percentage of your gains; although index trackers do not usually come with upfront costs a fee of up to 1% is applicable.
There is theoretically no limit on how much you can invest. However if you want to avoid paying income tax on dividends earned by your fund or capital gains tax you want to invest in an ISA. The ISA limit is £7000 in any one tax year (year to 5 April) so if you are quick you could invest £7000 this year and then another £7000 on 6 April and all would then be free from tax charges. However, the wise investor recommends paying a regular amount in and that way you don't risk buying at the top price but spread your investment over time.
There are many different indexes too, FTSE 100 (the 100 largest UK companies dominated by Banks, Drug companies, Oil Companies), FTSE 250 (the 250 largest companies but again weighted towards the bigger ones (which make up a bigger share of the index), The FTSE all share index is the whole london market.
Managed funds have varying risk profiles. A low risk fund has lower potential but less volatility. Over the long term you would expect to see greater returns with a tracker but you wouldn't have the risk associated with that. If you compare UK Trackers with UK managed funds, Trackers have been better over 10 years but managed funds have been better over 5 years. There are of course exceptions to the rule. If I was to risk a generalization, I would say that trackers are better when things are going up but not as good when things are going down.
Views are split (to say the least 
) on passive Index Trackers.
Trackers typically pay lower commission than actively managed funds, which is another reason why they are cheaper. Although active funds can also be bought through discount fund supermarkets which refund some/all of the commission that would otherwise go to the adviser.
I use the L&G range. Their UK Index fund has outperformed the Virgin Index fund significantly since the mid-90's, due mainly to its lower charges.
However, I would never buy a FTSE-100 tracker. Apart from the higher level of concentration, the performance is biased by having to buy shares that are entering the FTSE-100 (at artificially high prices because other FTSE-100 trackers are buying them too) while dumping shares that are leaving the index at low prices. In the long-term, an All-Share tracker is likely to outperform a FTSE-100 tracker with similar charges.
I don't believe that a poor performing fund is more likely to perform better in future. A poor performing company, yes, because it will get new management and might get taken over. But a poor performing fund has a poor fund manager and/or charges which are too high for the quality of fund management being provided.
Having chosen a market segment to invest in, e.g. UK equities, the argument in favour of tracker funds goes like this:
The index measures the average performance of all investments in the market. The market is made up of active traders and index funds. Therefore the index measures the average performance of active traders (before charges) because the index funds just follow the index (before charges).
Hence a tracker fund will match the performance of the average actively managed fund, before charges. However the tracker fund normally has lower charges than the average actively managed fund, so after charges the tracker fund will beat the average actively managed fund.
Tracker funds will never beat the best active fund manager. But they will consistently beat the average fund in the same sector, and very few fund managers can claim to do that.
Note this only works with funds in the same sector, eg. UK equity funds. A UK index tracker will not necessarily outperform the average cash, fixed interest, property or overseas equity fund. That would depend on how the different sectors perform relative to each other.
It is worth noting that exchange traded funds are likely to overtake traditional tracker funds in popularity since tracker funds lack the liquidity and flexibility (with an ETF you can set stop losses and exit instantly) that ETFs bring to the table.
When I first started investing, the first step I took was to mimic the world's greatest investor Warren Buffett. His mentor is Ben Graham who has written several books (in the 1930's although the principles apply to this day). For those who are just starting out, he advises investing in index trackers because the charges are low (much lower than mutual funds) and because of this they will perform better than the vast majority of mutual funds. He also advises drip-feeding money each month so you're not timing the market (and let's face it very few people have the skill to do it). There was also a good study done (I believe by Joel Siegel recently) who said someone who started investing in 1929 (just at the height of the stock market before its crash) and kept on investing (with dividends reinvested) right through the crash would still have made a 6% return. The moral of the story: he advises re-investing your dividends. So to recap, their advice is to start with an index tracker, invest a set amount per month and re-invest dividends. And keep in mind that most trackers pay dividends which can be re-invested...
It is said by advanced investors that the the more experience you have, the less likely you are to invest in an index tracker. I think Ben Graham would change that advice slightly such that the more experienced investor would expand on his/her core holdings of index trackers by researching stocks and finding companies whose market valuation is below its 'instrinsic' value.
It really is down to what you feel comfortable with. I would suggest doing as much research as you possibly can and not taking anyone's advice at face value without checking out the facts and finding out what they've got to sell you! Read as much as you can, follow what the best investors are doing (even if they have vastly different strategies), select a strategy you feel comfortable with and always be willing to learn and be flexible. Most importantly, set realistic expectations too.
Look at up-front costs, annual management costs, 'hidden' costs, transfer costs, tax implications etc. of any product being sold to you. Also, beware of those who compare trackers vs. funds over 5 years or so. Lies, damn lies and statistics come to mind. When comparing, compare over the duration of your investment lifetime. Got 25 years? That's what you should be comparing. Not 5 years. Mutual funds beat trackers? Not if an equity income fund charges 5% up front and a 1.5% amc. Will the same fund beat trackers in the next 5 years? Not likely if the star manager has just moved to start his own company. Good luck!
A point to note is that index trackers are even better in the United Sates than the UK as you've got more choice and can track different share types / geograhical sectors to suit your investment aims - e.g. there is a Nanotech index. In theory, you could build relatively diverse portfolios with trackers. Compare that to the limited range available as UK authorised UT/OEICs.
However, I discourage people from investing 100% into an index tracker. Lots did it in the boom times before the crash are only coming close to break even now. Put all your eggs in one basket and you are asking for trouble. The best form of risk reduction is diversification. This means a good spread of investments in different funds (managed by different houses), across different asset classes and different international markets.
All investments have risk attached to them.
Arguably its riskier to invest in cash than it is to invest in shares over the long term:
(i) Due to the potential eroding effects of inflation.
(ii) And the potential shortfall in return against investing in shares, or property, or other asset classes.
But of course that will depend upon various factors - timescale, an individual's attitude to risk, luck, ...etc.
There are some general points to consider:
The greater the potential reward the greater the potential risk.
Diversification helps protect against risk but it comes at a cost, like all insurance, which is that of reducing the potential returns as well as losses.
Risk can be spread between asset classes - cash, shares, property, etc.
Or Geographically - UK, Europe, Far East, North America.
Or Different Sectors
Or Different Company Sizes
You will get the point...etc
Within each group or class of assets consider further spreading risk by splitting your investments between separate institutions.
How many people know that the Financial Services Compensation Scheme for Banks and Building Societies only pays compensation to a maximum value of £31,700 - (100% of the first £2,000 and 90% of the remaining £33,000? One way of managing this risk would be to hold deposits in more than 1 bank or building society.
For investments that qualify, the maximum compensation figure is £48,000 (100% of the first £30,000 and 90% of the next £2000).
But payment will (the FSA's site says "may" worryingly) be paid out as a last result - ie, only if there is no likelihood of assets being reclaimed by the receiver/adminstrator. So almost certainly a long delay here at best - note the delay with split capital investment trusts. Or the uncertainty over the Rover pension scheme.
Its all very well saying a major bank, building society or financial institution won't go bust - history says otherwise - Barings, BCCI, Equitable Life (almost).
In my opinion an individual short access their objectives and their attitude to risk. If you have large sums in cash consider having it with more than one company.
If you are aiming for the top performing ISA's/Unit Trusts realize that this increases your chances of underperforming as well as, possibly, outperforming the market average. An indexed trust is likely to closely match (but underperform the market average) This year's best performing unit trusts/sectors often figure near the bottom of next year's tables and vice versa.
Consider diversification overseas - as the majority of most people's assets are in the UK. And property will be a large proportion of that.
I hope these points aren't construed as investment advice - they are just some points to consider.
And finally, if anyone thinks they are equipped to pick the best performing investment fund out of the several thousand on the market they are equally equipped to purchase individual shares.
Investment is a tough business - if it was easy we would all be very rich. I would say beware anyone who promises you high returns. Be skeptical. Ask questions. And try and understand as much as you can. Look at how the person selling you the product makes a living- will it be from the charges you incur?
I once read that if you managed a real return, after inflation, on 3%, it should be possible to safeguard your capital in the long term. Anything more and it requires progressively more risk. I have always thought it was a reasonable yardstick. Warren Buffet might not agree - but you will have to read his views elsewhere.
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