As the chasm between passive investment and active investment continues to grow, many are now looking towards tracker funds. On one side, we have tracker funds literally tracking the make-up of a particular index such as the Dow Jones industrial average or the NASDAQ, while on the other side we have investors using artificial intelligence and complicated mathematical formulas to beat the markets. Is it time to go back to basics?
What are tracker funds?
Tracker funds are basically investment funds which reflect the make-up/weightings of a particular index. If for example Google had a weighting of 2% of a particular index then 2% of the tracker fund investments would be in Google. As the make-up of individual indexes changes on a regular basis, any adjustments to Google’s weighting would mean either buying more shares or selling shares. It is fair to say that tracker funds are extremely popular because they are a passive type of investment which “follows the market”.
Why choose tracker funds?
Let’s assume you believe that US technology shares were undervalued but were not sure which individual share or shares to invest in. If you looked at companies in the NASDAQ index and their particular weightings you could create a mirror image with your own investment funds. As mentioned above, you would follow any adjustments to the index and particular company weightings as they are announced. The fact that the majority people do not have sufficient funds to create their own “mirror index” means that they will buy units in managed tracker funds.
The idea is that if you are correct in your assumption that, in this example, US technology shares will do well then you will benefit as the NASDAQ index rises. If you picked an individual technology share, as opposed to a tracker fund, and “got it wrong” then you would underperform the index. On the flipside of the coin, if you chose a share which outperformed the technology index as a whole then your return would be enhanced. However, volatile returns are often shunned by investors in favour of stable long-term appreciation.
Due to the way in which tracker funds are operated, as soon as a change in an index becomes live then the tracker funds have to follow. In the immediate aftermath of a change this can create significant buying or selling pressure on a particular share. As a consequence, one or more shares can become overbought or oversold. Indeed, on a regular basis tracker fund managers will need to either top up underperforming shares or part sell holdings in those which have outperformed. This ensures that the weighting for individual shares is a reflection of the underlying index. Constant tweaking!
As we touched on above, there will be situations where some shares may be overbought or oversold because of programme trades undertaken by tracker funds. In reality, there are more than enough active investors to use these arbitrage situations to bank their own profits on the upside and the downside. This will ensure that in time a share price returns to as near a neutral position as you would expect.
Those looking to invest in particular sectors as opposed to particular shares may well want to take a look at tracker funds. The ultimate type of “passive investment” they will ensure that your performance matches that of the underlying index thereby reducing the risk/reward factor associated with investment in individual shares. It is fair to say the tracker funds offer a more long-term investment approach.