The best argument against trackers

by Ed Bowsher on 11 March 2011  |  1 comment
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Two fund stars argue that investing in UK index trackers carries more risk than many people realise.

I suspect the debate about index trackers will never die. Fans of trackers will always say that trackers are the cheapest way to invest in the stock market. Meanwhile fans of active funds will always be prepared to pay higher charges in the hope that their funds can beat the market.

I’m not going to run through all the pros and cons for tracker funds in this post. I just want to look at what I think is the strongest argument against trackers. It’s the idea that index trackers are often overly slanted towards one or two sectors in the stock market. This certainly happened in 2008 when UK trackers were over-exposed to financial shares before the banking crisis.

These days, financial shares aren’t so predominant but UK trackers are now over-exposed to another sector instead. That sector is natural resources according to an article in this week’s Money Marketing. The FTSE 100 index currently has a 30% exposure in natural resources – 17.5% in oil and and 12.8% in mining.

So someone might invest in a FTSE 100 index tracker thinking they were getting broad exposure to the whole of the UK economy but instead find they were effectively making very big bets on the prices of oil and gold.

One well-known fund manager, Tony Nutt, is quoted in the article saying: “Mining has become a much larger proportion of the UK market than it ever was before. If you want to participate with an appropriate level of prudence, you should not use an index tracker.”

So is this argument valid?

Well, as I said at the beginning of this post, I think this is the strongest argument against trackers. I can’t dispute that if you buy a FTSE 100 tracker right now, you’re getting a lot of exposure to resource shares. And if the prices of oil and gold collapse, you’ll suffer.

But having said that this is the strongest argument against trackers, it’s not strong enough to change my view that trackers are the best bet for most people.

I say this because I know that some actively managed funds will be just as exposed to resources as trackers. Some even more so. The reason the FTSE 100 is currently slanted towards resource stocks is because they’ve been the ‘hot’ shares that have gone up a lot over the last year or so. Many active fund managers won’t have wanted to miss out on those rises and will own lots of resource shares as a result.

In fact, Tony Nutt himself is heavily exposed to this sector. 22% of his Jupiter Income Fund was invested in oil and gas shares at the end of January. Sure, if Nutt is really smart he might be able to sell his resource shares just before any crash - unlike the tracker funds which would have to stay invested. But the reality is that many active fund managers won’t make the right call. You could easily end up paying higher charges for a fund that performs less well than the trackers.

Tony Nutt is the perfect example of this. Money Marketing describe him as a ‘star fund manager’, but, in reality, his performance isn’t stellar in recent years. If you look at the performance of 86 funds in the Equity Income sector over the last three years, Nutt’s Jupiter Income trust comes 72nd out of 86. His fund has also lagged the market over the last two years. Personally, I think you’d be Nutts to invest in this fund. (Sorry I couldn’t resist.)

Given that both trackers and managed funds clearly have flaws, what can you do?

Well, firstly you could broaden your portfolio a little by investing in a fund that tracks the FTSE All-Share index rather than just the FTSE 100. The FTSE All-share comprises all of the companies in the FTSE 100 plus a large number of smaller companies.

Admittedly, the FTSE-100 index represents more than 80% of the All-share by value, so the diversification isn’t massive. But it’s better than nothing.

If you want to get some more serious diversification, you could track the FTSE 250 index. This index comprises the 250 largest companies on the London market excluding the large companies in the FTSE 100.  The nice thing about the 250 is that a lot of the businesses on this index are more UK-focused, so you’re making more of an investment in the UK economy as opposed to investing in large multinationals that operate all over the world.

Another option would be to track some overseas markets. The most obvious one would be the US which isn’t as tilted towards resource shares as the UK. Check out Legal & General US Index-Tracking ISA as one good way to invest in the American stock market.

So we’ve now looked at the strongest argument against index trackers and I think we’ve found that it’s not compelling. For most people, trackers remain the best way to invest in the stock market.

More:  The best investments for your ISA

PS. As I said in The best investments for you ISA, I do own shares in two actively managed funds. I've done that because I couldn't resist the temptation of trying to beat the market. But I probably should just stick to trackers.