The four biggest index tracker mistakes

by Malcolm Wheatley on 07 March 2011  |  7 comments
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Side-stepping these index tracker pitfalls can save you thousands, writes Malcolm Wheatley.

I'm a big fan of index trackers.  At a low cost, they offer a way for savers to buy a stake in Britain's biggest businesses -- affordably, without paying excessive commission, and without being exposed to the risks involved in buying individual shares.

For £50 per month -- or even less, in the case of some index tracker providers -- savers get to buy into a 'basket' of shares that make up a given stock market index.  Hence the name 'index tracker', of course.  The stock market goes down 1% in a day?  So do your shares.  The market goes up?  So do your shares.

And over the long term, the evidence shows that index trackers comfortably out-perform savings accounts, many times over.  The long-term rate of growth of the FTSE All-Share index, on a total rate of return basis, is over 10%.  That's far better than the return offered by a savings account -- which is why we at lovemoney.com are so keen on them.

But even so, pitfalls await the unwary.  So before you buy a tracker, adopt our goal on how to make money from the stock market and avoid these four massive mistakes:

1) Don't try to time the market

Time and again, research shows that private investors make the mistake of buying high and selling low.  That's right: the stock market goes up, and a tracker begins to look attractive, they pile in -- and then sit there nursing losses when the market moves back down again.

It's a classic mistake, but fortunately one that is easily avoided.  Don't view an index tracker as a quick way of making a killing on the stock market, but instead see it as a way of building long-term wealth.  In short, don't try and 'time the market', and don't invest money that you're likely to need in the short to medium term.

Instead, figure out what you can afford to invest each month on a long term basis -- ideally as an index tracker either within an ISA or a SIPP, both of which confer tax advantages -- and then stick to it.

That way, you're making a regular purchase of shares every month.  Not only are you avoiding the perils of having to time your buying decisions -- which even the experts get wrong -- but you're also handily taking advantage of something known as 'pound cost averaging'.  Simply put, you're buying more shares when prices are low, and fewer when prices are high -- which is as it should be.

2) Don't go foreign

But which index should you buy into?  Unless you're a super-sophisticated investor, stick to British stock markets to start with.

Yes, it is possible to buy overseas index trackers, either directly, or via low-cost ETFs, but doing so exposes you to higher charges, greater risk, and potential adverse currency movements.

That said, there are some very good overseas trackers and ETFs out there -- I'm particularly fond of Legal & General's Pacific Index fund, and HSBC's S&P 500 tracker, which follows the American stock market -- but until you've built-up a decent-sized stake in British companies, resist the allure of foreign shores.

3) Don't buy the wrong index

Britain has three main stock market indices, and some providers -- such as HSBC -- offer trackers covering all three.

Most providers, though, concentrate on just two stock market indices: the FTSE 100, which tracks the hundred largest companies quoted in London, and the FTSE All-Share, which tracks all the shares quoted on London's main market.  (The third index is the FTSE 250, covering mid-sized companies.)

Of the two, the FTSE All-Share is usually considered the safer bet.  It's more diversified, for a start: over 600 companies, not just a hundred.

It's also somewhat less concentrated on certain sectors.  Oil and gas shares, for example, make up 20% of the FTSE 100, but just 15% of the FTSE All-Share.  Banks, to choose another example, comprise 15% of the FTSE 100, but just 11% of the FTSE All-Share.

The FTSE 100 also contains some enormous foreign companies -- mining shares as such as Russian miner Kazakhyms, Chilean company Antofagasta, and Indian miner Vedanta Resources.  You can't avoid them altogether: they're in the FTSE All-Share index, of course, but they are present there in a little less concentrated form.

Finally, mid-sized companies tend to grow more quickly.  As the saying goes, elephants don't gallop -- and the FTSE 100 contains a decent-sized helping of some of the worlds very largest businesses: companies like Shell, Barclays and GlaxoSmithKline.  Buying into the All-Share buys you a stake in mid-sized companies that are set to gallop.

4) Don't pay too much

Finally, when you've selected an index to track, avoid over-paying for your tracker.  Some providers -- such as Virgin -- charge an annual management fee that is as much as 1%.  And that for what is in effect a bog-standard fund, largely managed by a computer!  What's more, some providers charge even more.

Avoid these high-charging companies like the plague.  As I explained here, there are much cheaper tracker products on offer -- among them Legal & General's giant FTSE All-Share tracker, the UK's largest, as well as even cheaper offerings from HSBC, Vanguard, and Fidelity.

Another good tip: don't rely just on the annual management fee that providers quote, but also dig out their Total Expense Ratio, which gives an even better idea as to the real cost of owning a tracker.  While not every provider readily volunteers the information, it's usually available if you dig around.  Handily, it turns out that HSBC, Vanguard, and Fidelity all offer trackers with a low Total Expense Ratio.

Remember: the less you pay a tracker provider in fees, the more of a tracker's return is available to be invested in future growth.

Take out an index tracker via lovemoney.com

Full disclosure: Malcolm has trackers with Legal & General, HSBC, and Vanguard.