Tracker funds: for passive stock market investment.
Ever heard of a tracker? No, it’s not some gadget from a James Bond film! In the world of finance, a tracker is an investment fund that replicates a stock market index. myLIFE is on hand to explain how it all works.
Passive management of your investment
A tracker, or an exchange traded fund (ETF) if it is listed, is a fund that replicates the performance of an index by tracking its rises and falls. This means that if the chosen benchmark index (CAC40 or NASDAQ, for example) gains 5% over a one-year period, so does the tracker. However, if the benchmark loses 5%, the tracker does too.
Whereas most investment funds are managed by financial analysts looking to outperform the market (active fund management), trackers are managed passively. They are happy just to replicate the performance of an index without aiming to beat it. This means their objective is to provide investors with a return that is as close as possible to the one delivered by the index in question. As a general rule, robo-advisors fill their portfolios with trackers.
Trackers can also replicate an asset (e.g. the price of gold) or simply a known strategy. In this article, we will focus on trackers that replicate an index.
How do trackers replicate the performance of an index?
There are several ways to replicate the performance of a benchmark index.
- Physical trackers invest directly in the assets that make up the index. This is simple replication, guaranteeing a return close to that delivered by the benchmark.
- Instead of investing in the securities of the index themselves, synthetic trackers invest in derivatives that imitate its performance. A third party (management company or financial institution) invests in a basket of securities of its choice, then transfers the index performance to the tracker.
The difference between the tracker and the benchmark must not exceed 1.5% of its value.
There are also leveraged trackers, which amplify the gains or losses of the index. It goes without saying that you should consult an expert about the risks associated with this kind of investment before committing to it.
Lastly, short trackers bet on the index falling: the worse the index performs, the higher the tracker’s return! Simply put, if the index falls by 1%, the tracker gains 1% (and vice versa).
You should be aware, however, that there may be slight differences between the value of the benchmark and the tracker. Performance is never identical. Among other things, this may be caused by:
- The purity of the replication, i.e. the tracking error. This is a statistical measure of the volatility of the gap between the tracker’s performance and that of its index.
- Any fees deducted, i.e. the tracking cost.
There are a load of other factors, some more technical than others, that might influence results. These include transaction and rebalancing costs, sampling, cash drag, timing and securities lending. We recommend you speak to your investment advisor to find out more.
An investment vehicle for everyone
Whether you’re an old hand or taking your first steps, putting your money in a tracker is a simple and often affordable way of investing in the stock market. Remember to weigh up all the pros and cons beforehand, though.
A tracker’s passive management means it is cheaper than an actively managed investment fund.
Pros of a tracker
A tracker’s passive management means it is cheaper than an actively managed investment fund.
A tracker also has the advantage of providing access to a diversified portfolio in a single transaction. It’s as if you are investing in several companies at once. The assets can therefore cover a geographical area, an index (Dow Jones, CAC40, NASDAQ, etc.), a sector (telecoms, energy, etc.) or an asset class (gold, currencies, oil, etc.).
Moreover, unlike many traditional investment funds, the tracker is permanently listed if it is an ETF. This means that its value is updated every 15 seconds and it can be traded from the opening to the closing of the stock exchange.
Cons of a tracker
You must remember that passive management means the tracker’s value is directly linked to the performance of the benchmark index. As such, the fund is exposed to all the risks of its constituent financial instruments, and investors may very well lose all their capital.
Don’t wait until the market collapses to ask yourself about the reality of the replicated index or the liquidity of the tracker (figures available on purchase and sale). Why not? So you don’t risk betting on a market that is about to turn around, and avoid being unable to sell your assets when you want to.
The financial crisis of 2008 serves as a warning from history: remember that if you invest in derivatives (as with a synthetic tracker), there is always a counterparty risk as well.
To conclude, no matter where you put your money, be it in a tracker or some other investment vehicle, there is always some kind of risk involved. Don’t take investment decisions lightly! Before making your choice, you have to decide what your objectives are, estimate your investment horizon and be aware of your investor profile. You are the key to sound investment. For more information on trackers, ask your investment advisor.
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