Index trackers: The good, the bad, and the ugly

Commentators often describe index trackers as plain and simple vanilla funds, benign enough for even the most inexperienced retail investors. But in reality, the investing industry is a hothouse of evolution, continually breeding products that pass themselves off as cuddly trackers, but which can conceal retractable claws.

The following product types may all be classed as index trackers, although I only use the term to describe index funds and ETFs in my Monevator articles.

These other varieties are weighed down with features and risks that need to be properly understood before you dive in.

A not very scientific index tracker meter

Index funds

The most straightforward tracker type of all, low-cost index funds should be first choice for inclusion in your passive portfolio. Index funds:

  • Generally invest in a diversified range of equities or bonds.
  • Physically own the assets of the indices they track – though the fund may only own a sample of the index.
  • Are open-ended so their price closely matches the underlying index.
  • Trade once a day.

Physical ETFs

Physical Exchange Traded Funds (ETFs) are very similar to index funds except that:

  • They’re traded on the stock exchange, through brokers.
  • You can buy and sell ’em throughout the day like shares.
  • They incur trading costs, so are more suitable for larger investment sums.
  • Huge product diversity lets you fine tune your portfolio.

Synthetic ETFs

Synthetic ETFs are riskier and trickier than physical ETFs. They should only be used if you fully understand the differences between the two.

Synthetics trade like physical ETFs, except:

  • They don’t actually own the assets of the indices they track.
  • Instead, they buy a total return swap. That’s an agreement with another financial entity to pay the ETF the return of the index.
  • European regulations limit the exposure to 10% of the ETF’s net asset value.
  • Collateral should cushion the ETF from counterparty disaster.

Investment Trust trackers

There aren’t many of these beasties about. They’re quite similar to physical ETFs in that they’re:

  • Listed on the Stock Exchange.
  • Bought through brokers.
  • Traded in real-time.

The additional complication with Investment Trusts is that they are closed-ended funds. They have a fixed amount of shares in circulation, so the trust’s price at any moment reflects supply and demand for the fund itself, as well as for the underlying index. Investment Trusts can therefore trade at wide discounts to their net asset value and sometimes a slight premium. You can lose or gain on an investment trust as the discount fluctuates, even if the index remains absolutely flat.

ETCs – commodity or currency tracking

Exchange Traded Commodities (ETCs) can track everything from gold to leveraged lean hogs but they’re not as straightforward as their ETF namesakes:

  • Only a few precious/industrial metal ETCs can afford to physically hold commodities, which enables them to track the current (spot) price.
  • Most ETCs track their commodity’s futures market. Returns on futures differ from returns on spot prices.
  • Some ETCs track single commodities, others a broad basket.
  • ETCs are structured as debt instruments to avoid UCITS rules on diversification.
  • Investors are exposed to counterparty risk (up to 100%).
  • You don’t get dividends.

Exchange Traded Currencies are similarly structured and track the foreign exchange fluctuations of pairs of currencies.

ETNs and Certificates

Exchange Traded Notes (ETNs) and Certificates are cheap and potentially nasty. There are many variations on the theme, but basically they track an index, are tradeable on the Stock Exchange, and:

  • They’re debt instruments issued by a single party (normally a bank).
  • The bank agrees to pay the return of the index on the product’s maturity date.
  • The underlying assets are not physically owned.
  • If the bank goes kaput you’re in trouble.
  • Counterparty risk exposure is up to 100%.
  • They’re a low cost way to enter hard-to-access markets.

Structured products

There’s a whole soup of structured products out there that are labelled as trackers. Normally they’ll follow an index of some sort and lure investors with alchemical promises of outsized returns and capital protection.

Broadly:

  • They’re close ended.
  • Have a finite lifespan.
  • Capital protection is only offered if you hold for the full lifespan of the product.
  • The return is provided by derivatives.
  • It’s counterparty risk time again.
  • You give up your dividends.
  • You’ll scratch off your scalp trying to fathom how they work.
  • There’s no free lunch!

What you track matters mightily

Just because you’ve invested in the kind of fund you’d happily take home to meet your mother – a traditional index fund or physically-replicating ETF tracker – that doesn’t mean you’ve necessarily bought a vanilla fund in terms of the exposure you’ve taken on.

I’ve described the different tracker type vehicles – but I haven’t got into the passengers in the vehicle, or where you hope it’s going.

An index fund may seek to track a mainstream index like the FTSE 100 index of the UK’s largest companies, the S&P 500 in the US, or the entire global stock market.

But innumerable funds are available that seek to track all sorts of other weird and wonderful indices (and yes, “weird and wonderful” may be considered a euphemism for “odd and unsuitable” for us passive investors).

I’m thinking about specialist indices creating in-house by fund managers to track niche sectors – companies involved in robotics or selling to teenagers or global arms, say.

These products might have their place for thrill (/loss…) a minute active investing sorts, but they have nothing to offer us sober passive investors.

You might also come across ETFs that aim to, for example, double the daily upside or downside of the index being tracked. Again, back away slowly.

More respectable from our perspective are funds that track indices dedicated to winkling out the potential return premiums from certain cohorts of shares (sometimes called Smart Beta funds) that focus on value, profitability, and similar factors, where you might hope to boost your annual returns by a percentage point or two over the long-term.

But such funds have extra risks and other downsides, too, so make sure you do your research.

Just remember the type of index tracker you plump for is one thing – but the index being tracked is a separate matter.

Take it steady,

The Accumulator

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