Investing in a fund or a tracker?

03/14/2022

Some investors swear by cheap index funds, others look for active funds that outperform the index. Whichever choice you make, in both cases you must do your homework so as not to return home from a bare trip. Funds and trackers can be interesting instruments for novice investors. Not only are they highly diversified investments, they are also monitored by a professional. What the investor should take into account is the immense range of funds and trackers. As a result, he still has to work on his own to make the right choices. Dozens of fund houses are active on the market, which together offer thousands of funds. There are also several providers with a very wide range of trackers.

Whether you choose a fund or a tracker, the most important question to answer first is what you want to invest in. Everything starts from your investment objective and the risk you are willing to take. If you want to build up a savings account for your pension, a full investment in shares may be appropriate. If you need your savings in five years' time, it may be better to build in a little more caution. If it is your first investment, opt for the widest possible spread. An equity fund, this is a fund that can invest in all regions and sectors. In that case, the trackers are, for example, a tracker that is based on the global stock index MSCI World.

Once you have decided how you want to invest your savings, it comes down to choosing the right product. Do you opt for an actively managed fund that aims to outperform the market? Or do you opt for a cheaper tracker, which aims to provide the same return as the index? Make no mistake, both funds and trackers often fail in those objectives.

The research firm Standard & Poor's compares the performance of active funds with that of the relevant S&P indices every six months. It shows that over a 10-year period, only 17.5 percent of funds that invest in US stocks outperform the S&P500 index, which pools the largest 500 US stocks. The picture is no better for European equities. Compared to the S&P Europe 350, only 15.2 percent of funds outperform over a 10-year period. An important explanation lies in the index huggers, so-called active funds that are close to their reference index. As a result, after costs, they show a return that is (slightly) below that of the index.

Less research has so far been conducted into the performance of trackers, but it is clear that trackers do not always follow their index as successfully. Sometimes the return differentials between the tracker and the index can be high.

You need to do your homework to find the right fund or tracker. The following rules of thumb may help.

Find the right fund

High-performing funds have some common characteristics.

1. Active management

If funds want to outperform their benchmark index, they must invest differently from that index. There are several ways to identify such funds. In the fund sheets you will often find the composition of the fund. Some fund houses compare this composition with that of the reference index. Then you can quickly see to what extent the funds are actively managed. You can also look at the fund's top ten positions and the weights. If they are close to those of the reference index, you are dealing with an index hugger. The high costs you pay this administrator are money wasted. Some fund providers charge an 'active share' for their fund. This percentage indicates the extent to which the fund deviates from the benchmark index. A percentage of 100 indicates that there is no overlap between the fund and the index. A percentage of 0 indicates that the fund is a copy of the index.

2. Performance

Deviating from the index is of course not sufficient. The stock pickers must also have proven that their strategy leads to an extra return and that the funds outperform the benchmark index. More and more fund houses are including the return of the benchmark index in their key investor information when summarising the returns over the past ten years. This shows at a glance how actively the fund is managed and to what extent it manages to outperform the benchmark each year. You should preferably choose funds that show great regularity and consistently outperform. This regularity is also an important criterion at Expat Fiduciary Advice, i.e. rating that is assigned to investment funds based on their performance over the past five years. Funds with three stars beat their peers on a regular basis, funds with zero stars underperform. An important quality criterion is the performance of a fund in a declining market. Often, those high-performing funds have some common characteristics. Equity funds are often funds that hold highly concentrated portfolios. The number of shares in the winning equity funds is always below 50. The managers also stick to their beliefs, regardless of the issues of the day, and on average keep the shares in the portfolio for a relatively long time.

3. Risk

The risk is also included in the star rating. It is best not to choose funds that take too great a risk. A good indicator is the fund's performance in a declining market. If funds score significantly worse than their peers in a declining market, this usually indicates above-average risk. Therefore, look at how the fund performed during major stock market corrections, such as at the start of the corona crisis or the outbreak of the war in Ukraine.

4. Cost

Finally, it is also important to look at the costs of your fund. In the key investor information you will find the annual charges expressed as a percentage. For equity funds, these costs are usually between 1.3 and 1.8 percent per year, although there are also funds that charge more than 2 percent! At such high costs, the manager already has to outperform the index by more than 2 percentage points each year to offset the costs.

Find the right tracker

It is best not to blindly invest into a tracker. One tracker will have a greater deviation from the reference index than the other. This has to do with the costs, which remain below 0.4 percent per year for most trackers. But there is much more to it than cost.

1. Replication

An additional reason for deviation lies in the way the tracker mimics (replicates) the return of the index. The quality with which the index is mimicked is not reflected in the cost. We remember a few years ago a tracker provider who charged 0 percent for a tracker on the Eurostoxx 50 index, but when you compared the returns to the index, there was a return difference of 50 basis points. That difference had to do with the fact that the tracker was using synthetic replication. With such a replication, the trackers will buy baskets of shares and 'exchange' the performance of that basket via a swap with the performance of the index. In synthetic replication, part of the yield can sometimes be lost due to hidden costs related to the specific construction. Also in terms of counter party risk, you sometimes have to be careful with this replication. The physical replication is clearer in that regard. In a full physical replication, the tracker will buy all the underlying stocks of the index. However, if the index contains too many stocks, or stocks that are more difficult for the provider to trade, physical replication with optimisation is often chosen. In that case, the majority of the shares of the index are bought, but not all or some shares are bought on another exchange. For example, trackers shadowing MSCI Emerging Markets physically buy stocks until they are representative of the index. Obviously, that form of replication cannot guarantee a 100 percent exact copy. Sometimes that method can also lead to a return higher than the index. And then there's the specific replication of bond indices. Keep in mind that bond trackers automatically have much less tracking than stocks due to some specifics of those bond indices.

2. Index

Important when comparing two trackers that apparently shadow the same index: pay attention to the details. A common mistake is that investors do not sufficiently view the tracker's reference index. The names of the indexes can be long and look similar at first glance. Sometimes there is a version where a maximum is placed on the largest positions of the index, while this is not the case with the other version. You can't always just deduce that from the name of the tracker. The message is to be careful.

3. Negotiability

It is also important to look at the tradability of the tracker. Larger trackers often offer better liquidity, so the difference between the bid and ask price is smaller. In addition, those trackers can take advantage of economies of scale, allowing them to smooth out their transaction costs. You can opt for a tracker that charges 1 basis point less, but if the volume of the tracker is small, you can easily lose that 1 basis point to higher transaction costs. Between two funds tracking the same index, investors often prefer the larger, more liquid option. You can opt for a tracker that is 1 basis point cheaper, but if that tracker is small, you can lose the advantage to higher transaction costs.

4. Taxation

There is the taxation. This can also explain yield differences between apparently the same trackers. Trackers that shadow an index including dividends often opt for a Net Return Index. This is an index in which dividends are included less 30 percent withholding tax. But if you launch an Irish tracker on that index, it only has to pay 15 percent withholding tax on the dividends. In that case, the tracker will by definition outperform the index. A Luxembourg tracker on the same index will be subject to 30 percent withholding tax. The stock market tax also plays a role. It depends on two factors: the distribution policy and the country where the tracker is registered. If the tracker is registered in the European Economic Area (EEA), a stock exchange tax of 0.12 percent applies on purchase and sale. Always check carefully which stock market tax applies before you step into a tracker.


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