What it means
The term is used mostly in the UK and some other markets, while in the US the same product is usually called an index fund. A tracker fund is a mutual fund or exchange-traded fund (a fund whose units trade on a stock exchange) that follows a chosen index mechanically.
If the index holds 500 companies in set proportions, the tracker holds those companies in the same proportions, adjusting when the index changes. Because the manager is not trying to pick winners, there is little research cost and low trading activity, so charges are far lower than those of actively managed funds.
The fund's goal is to deliver the index return, but it never matches exactly. The gap is called tracking difference, which is mainly the fund's fees plus small effects from trading costs, cash held and the way dividends are handled.
Another measure is tracking error, which shows how much that gap varies from period to period. A well-run tracker has a small tracking difference and a very low tracking error, and these are the figures to check before buying.
Some trackers hold every share in the index, called full replication, while others hold a sample, and some use derivatives (contracts whose value depends on the index) to copy it. The method matters because it affects costs and risks, including the risk that a counterparty to a contract fails.
Tracker funds are a core holding for individuals, pension schemes and companies investing surplus cash for the long term. They are not risk free, as the fund will fall when the market falls, but they offer broad diversification at a very low cost.
In practice
Real-world examples.
Example
An office worker saves $400 a month into a tracker fund that follows a broad share index. She expects to earn roughly the market return less a small annual charge, and she does not have to choose individual companies.
Example
A family charity places $300,000 in a bond tracker fund as the stable part of its investments. The trustees like that it spreads the money across hundreds of bonds and costs a fraction of an active manager.
Example
A company's pension committee compares two trackers on the same index. One charges 0.10% and has a tracking difference of -0.12%, while the other charges 0.35% and has -0.37%, so the committee chooses the first.
Formula
Calculation
Tracking difference = Fund return - Index return
Suppose a broad stock index returns 8.00% over a year, and a tracker fund following it returns 7.85% after charges. Tracking difference = 7.85% - 8.00% = -0.15%. If the fund's annual charge is 0.15%, this shows that almost all of the gap is explained by fees. On a $50,000 investment, the shortfall against the index is 50,000 x 0.0015 = $75 for the year.Case study
Seen in the real world.
Eastgate Textiles is an illustrative, fictional company whose pension scheme held $6,000,000 in an actively managed share fund charging 0.85% a year. Over five years the fund's performance had lagged its benchmark index by an average of 0.7 percentage points a year.
The trustees compared it with a tracker fund on the same index, charging 0.10%. On $6,000,000, the annual fee difference was 6,000,000 x (0.0085 - 0.0010) = 6,000,000 x 0.0075 = $45,000.
They moved the money into the tracker and kept a small allocation with a specialist manager. The illustrative result was lower costs and a return very close to the benchmark, and the lesson was that fees are certain while outperformance is not. The trustees also asked the administrator to report tracking difference every quarter, so that any drift between the fund and its index would be spotted and explained early, and to confirm each year that the fund's charges had not changed.
Watch out
Common mistakes.
- Assuming a tracker fund will give exactly the index return, when fees and trading costs create a small shortfall every year.
- Choosing a tracker only on its past performance, when the better tests are its charges, tracking difference and how it copies the index.
- Thinking a tracker protects against falling markets, when it will fall by roughly as much as the index it follows.
Questions
People also ask.
What is the difference between a tracker fund and an index fund?
In practice they are the same idea, with "tracker" used mostly in the UK and "index fund" mostly in the US.
Are tracker funds safer than active funds?
They avoid the risk of a manager picking badly, but they carry the full risk of the market they follow, so they are as risky as the index itself, and investors should be ready for periods when the whole market falls by 20% or more.
Do tracker funds pay dividends?
Yes, they pass on the income from the investments they hold, either by paying it out or by reinvesting it, depending on the unit class chosen.
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