How do I choose between a tracker fund and an active fund?

Full answer

A tracker fund (also called an index fund) is designed to simply replicate the performance of a specific market index — such as the FTSE 100, FTSE All-Share, S&P 500 or MSCI World — by holding the same (or a representative sample of the same) constituent shares in proportion to their weighting in the index, with minimal ongoing intervention or stock-picking decisions by a manager. Because there is no active decision-making about which shares to buy or sell (the fund simply follows the index's own rules), tracker funds have very low ongoing charges, commonly in the range of 0.05% to 0.25% a year. An active fund, by contrast, employs a professional fund manager (or team) who researches individual companies and makes deliberate decisions about which shares to buy, hold or sell, aiming to outperform a relevant benchmark index — this hands-on approach costs considerably more, with typical ongoing charges of 0.5% to 1.5% a year or more, reflecting the manager's research team, trading costs and, in some cases, a performance fee on top. A substantial and consistent body of long-term academic and industry research — including regular studies such as the SPIVA (S&P Indices Versus Active) scorecards — has found that a majority of actively managed funds underperform their relevant benchmark index over periods of 10, 15 and 20 years, once fees are taken into account, largely because the higher costs of active management are a persistent drag that skilled stock-picking only rarely and inconsistently overcomes across a large enough sample of funds and time. This evidence is why many long-term, cost-conscious investors (and increasingly, financial advisers using model portfolios) build the core of their portfolio around low-cost tracker funds, sometimes supplementing with a smaller allocation to active funds in specific areas (such as smaller companies, emerging markets, or specialist sectors) where there is somewhat stronger historical evidence that skilled active management can add value net of fees. Neither approach eliminates market risk — both tracker and active equity funds can still fall significantly in value during a market downturn, since a tracker fund by definition falls exactly as much as its underlying index. Use the Compound Interest calculator to model how a cost difference of even 0.5-1 percentage point a year compounds over a long investing horizon.

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