When many of us think about how to get our savings stack built up, we turn first to ISAs. That’s understandable. After all, ISAs are tax-free – the interest you earn on your money is completely beyond the clutches of the taxman, something that appeals to all of us!
However, we don’t always consider that there are two different types of ISA. And by ignoring Index Trackers, we’re missing out on more tax-free savings.
The rules
With ISAs, you’re allowed to save up to £10,200 each tax year, of which a maximum of £5,100 can be saved in a Cash ISA.
Many savers are content to stick to the cash limits. However, by doing so they miss out on their full allocation of tax-free savings - in fact, unlike with Cash ISAs, you can use all of your annual £10,200 ISA limit with stocks and shares ISAs!
How it works
So what is an Index Tracker ISA?
An Index Tracker replicates (in other words, tracks) the performance of a certain index. It does this by investing your money into the shares of all of the companies quoted on that index. So if you put your savings into a FTSE 100 Tracker for example, your money will be used to invest in shares in each of the top 100 companies in the UK.
Inflation is the enemy when it comes to your savings because it attacks real returns, and reduces the purchasing power of your cash.
So if the FTSE index has a bad day, and its value falls by 5%, so does the value of your savings. But if it has a good day, and rises by 5%, your investment will do the same (though there will be a deduction for fund charges).
The pros
There are a number of big selling points to Index Trackers.
Index Trackers offer those people who fancy trying their hand at a little investing the chance to do so on a very affordable basis. For example, the Legal & General UK 100 Index-Tracking ISA only requires a minimum monthly investment of £50, with no initial charge. So if you have a spare few quid every month, these funds offer you the chance to try your hand at investing, without having to commit a small fortune towards it.
However, make sure you check out the management charge – some funds charge as much as 1%. Given the fund itself enjoys no actual management, that’s an awful lot!
Simplicity
One of the things that puts many people off investing is that it all seems a bit complex. No such worries with Index Trackers. If the index goes up, so does the value of your investment, if the index goes down, likewise.
Plus, you don’t need to spend your time trawling through the investment pages of the broadsheets, trying to work out which sector to invest in – everything is done for you.
Performance
Index Tracker funds often boast an even better return than actively managed funds. The reasoning is quite simple – managed funds rely on fund managers, who are only human, and so are liable to making poor decisions in terms of which businesses to invest in.
The cons
However, there are also a number of potential downsides that you should be aware of before you rush off to open an account.
Some critics of tracker funds think that the passive nature of a tracker fund exposes your money. For example, financial firms make up a big proportion of the FTSE 100. Should the financial markets go through (another) period of difficulty, the fund is then exposed to this. With a managed fund, the fund manager would move your money out of this sector and into other sectors which were not going through such problems, protecting your cash. That doesn’t happen with Index Trackers.
Exchange rates
It’s not just those firms that are listed on the UK Stock Exchange that you can invest in – there’s a wide variety of funds tracking the performance of US, European and Pacific indices, among others. However, while this can be very tempting (it sounds so much more exotic!) remember that when you put your money into such funds, you have to consider currency fluctuations as well as the performance of the index itself!
Tracking error
No tracker exactly mirrors the performance of the relevant index, due to the different tracking strategies the various funds employ. However, you can work out how close it will get by checking out the fund’s tracking error figure. Obviously, the lower the figure, the better! So make sure you do your research on this before you sign up with an Index Tracker, as the performance can vary.
What are your thoughts on index trackers? Please let us know using the comments box below.