How best to track the market

Understandably, most investors assume that if a fund claims to track an index, their return will be exactly the same as the index. There are a number of reasons why this might not be the case: costs, for example, will have an influence, but perhaps most importantly, index tracking funds use different methods to track the index. This can result in a variation in performance.

The key difference between funds is whether they aim to replicate the performance of an index by physically investing in all the stocks within the index, or they choose a ‘synthetic’ strategy, using derivatives to mirror the performance of an index.

In a physical replication strategy, the fund manager will usually simply invest in all the stocks in the proportion in which they are represented in the index. So if the FTSE All Share has 5% in HSBC, the passive fund will hold 5% of its fund in HSBC. It will then buy more, or sell, to accommodate movements in the share price.

Where liquidity becomes more scarce, notably in smaller companies, funds of this type will use ‘sampling’ to gain access. Rather than buying each individual stock, they will buy a selection of representative stocks to mirror index performance. They may even introduce some ‘active’ element to this, seeking to buy those particular shares that have the best chance of good performance.

In the Aberdeen UK Tracker, for example, we seek to match the performance of the FTSE All Share in both income and capital terms. We invest fully in the largest 350 stocks and the majority of the smaller cap names. However, within the FTSE All Share there are a number of small, illiquid investment trusts, which may only trade every few weeks. This can add costs and complexity, so we a sampling technique to gain access to this part of the market.

Physical replication is the most straightforward and transparent way to track an index. It can be marginally more expensive as there will be transaction costs incurred in physically moving in and out of stocks. However, an All Share tracker will tend to have fewer trading costs than a FTSE 100 or FTSE 250 tracker because it does not have to buy or sell when stocks move between the large and mid-cap indices. Also, we aim to minimise trading costs by investing at peak trading periods around index rebalancing, when brokers offer discounts for high volume.

The investment trust structure also has some advantages: Open-ended funds create and cancel units in line with investor inflows and outflows, so there is constant movement within the portfolio. Investing inflows or selling holdings to fund outflows incurs transaction costs, which act as a drag on performance and increase tracking error.

Physical replication strategies will usually adjust their portfolios quarterly to reflect the new index weights. This can lead to some disparity between the index and the fund performance in the interim, but this usually adjusts over time. If there are significant changes intra-quarter, trackers may make an exception. For example, in the Aberdeen UK Tracker, new initial public offerings (IPOs) will be included if they represent more than 1% of the full market capitalisation of the FTSE All Share Index.

The alternative to physical replication is synthetic replication. This approach uses derivatives to replicate the performance of an index. An index fund of this type doesn’t hold any of the shares within an index, but instead makes an agreement with a counterparty (usually an investment bank) that it will pay the return of its capital plus the performance of an index.

This sounds straightforward, but introduces a number of risks. Prior to the credit crisis, for example, no-one really considered the possibility of an investment bank going bust. During the crisis, this possibility became all too real. In order to protect against a situation where the issuer of the derivative is not in a position to honour its commitments, every deal is backed by collateral.

In theory, this should protect investors. If the investment bank goes bust, investors can call on the collateral and get their money back. The trouble is, it might not be the amount they are expecting. There are restrictions on collateral, but it could be held in equities, bonds or cash. This may give a better or worse return than the index return investors were expecting, but it could be different.

Synthetic replication is often used by exchange traded fund providers and may track the index more closely. However, investors need to be sure that they receive the income as well as the capital return as compound income is an important source of returns over time.

Although the method of index tracking will influence the return to end investors, costs are important as well. This is not simply the cost of the fund, which is usually clear from the fund’s literature, but also how that fund is bought. Different platforms may have a more favourable cost structure for buying different types of passive funds. For example, research from Edison suggests while investing £100 a month in the Aberdeen UK Tracker direct with Aberdeen would cost £9.60 over a year, it would cost over £100 to invest the same amount on one platform with a flat annual fee of £75. A lump sum of £15,000 (equivalent to one year’s ISA allowance) produced a narrower range of results, with the cost of owning the trust ranging from £120 (again, through Aberdeen’s share plan) to £131.95.

Tracking an index is a relatively straightforward way to gain access to the market and to build a diversified portfolio. However, there are still decisions to be made. Each tracker will vary slightly in its approach, so investors need to ensure they are comfortable with the way a fund tracks the index and the costs incurred.

 

Important information

Risk factors you should consider prior to investing:

• The value of investments and the income from them can fall and investors may get back less than the amount invested.

• Past performance is not a guide to future results.
• Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.

• The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.

• There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.

• As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bidoffer spread. If trading volumes fall, the bid-offer spread can widen.

• Yields are estimated figures and may fluctuate, there are no guarantees that future dividends will match or exceed historic dividends and certain investors may be subject to further tax on dividends.

 

Other important information:

An investment trust should be considered only as part of a balanced portfolio. Nothing herein constitutes investment, legal, tax or other advice and is not to be relied upon in making an investment or other decision. No recommendation is made, positive or otherwise, regarding individual securities mentioned. This is not an invitation to subscribe for shares in the investment trust and is by way of information only. Subscriptions will only be received and shares issued on the basis of the current Key Facts document. These can be obtained free of charge from Aberdeen Fund Managers Limited, PO Box 9029, Chelmsford, CM99 2WJ.

 

Issued by Aberdeen Asset Managers Limited. Authorised and regulated by the Financial Conduct Authority in the United Kingdom.

A full list of the risks applicable to this investment trust can be found in the factsheet which is available at www.aberdeenuktracker.co.uk.