Tracker funds and exchange traded funds

Market index following the overall performance of a selection of investments

Tracker funds and exchange-traded funds (ETFs) are investments that aim to mirror the performance of a market index. A market index follows the overall performance of a selection of investments. The FTSE 100 is an example of a market index – it includes the 100 companies with the largest value on the London Stock Exchange.

Index performance
These are financial instruments you buy from a fund company that aim to track the performance of an index. ETFs do the same but are listed on a stock exchange and can be bought and sold like shares. Trackers and ETFs are available to track many indices.

Trackers and ETFs work either by physically buying a basket of investments in the index they’re tracking or by using more complicated investments to mimic the movement in the index.

Lower charges
Investment decisions are made automatically according to the fund’s rules. This passive trading makes index trackers cheaper to run than actively managed funds, so many have lower charges.

With index trackers, you own a share of the overall portfolio – if the value of the assets (shares, etc.) in the fund rises, the value of your share will rise. If the value of the assets falls, then so will the value of your share.

Asset class
Index trackers are a way to spread your risk within an asset class without having to spend a lot of money.
The tracked index can go down as well as up, and you may get back less than you invested. Because of charges, a tracker will usually underperform the index somewhat, and over a long period that underperformance could be more noticeable.

Good fit
Before investing, make sure you understand whether the index tracker is physical or synthetic and whether it is a good fit for your goals and risk appetite. A synthetic tracker is an investment that mimics the behaviour of an ETF through the use of derivatives such as a swap.

Synthetic tracker funds and ETFs rely on a counterparty underwriting the risk, and so carry the risk of counterparty failure (for example, Lehman Brothers in 2008). There are various controls which aim to reduce this risk.

Market conditions
Assessing the risks in synthetic tracker funds and ETFs may be difficult. Many ETFs are not based in the UK. You can sell at any time, but the price you get will depend on market conditions on the day.

ETFs offer minute-to-minute pricing because they trade like a share so may be more appropriate than tracker funds for investors who trade more frequently. However, it is generally better to hold this type of investment for the longer term – you can ride out ups and downs in value and pick your moment to sell.

Dividend Allowance
The current tax-free Dividend Allowance is £2,000 (2018/19).
Dividends received by pension funds or received on shares within an Individual Savings Account (ISA) will remain tax-efficient and won’t impact your dividend allowance.

There are three dividend tax bands which currently apply to all dividend income in excess of £2,000 per year:

7.5% (for basic rate taxpayers)
32.5% (for higher rate taxpayers)
38.1% (for additional rate taxpayers)

If your fund has invested in corporate bonds, gilts or cash, it should pay interest, and that interest will be treated differently to dividend income.

You are entitled to a personal savings allowance (2018/19). This means you don’t pay tax on the first £1,000 you earn from interest from:

Bank accounts
Building societies
Savings accounts
Corporate bonds
Credit union accounts
Government bonds and gilts (or the first £500 if you’re a higher rate taxpayer).

Any profit you make when selling your shares or units counts towards your Capital Gains Tax annual exempt amount. Losses can be offset against other gains in the same tax year or carried forward to future years.