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Tracker Funds: What They Are, How They Work, and Examples

Last updated 03/20/2024 by

Abi Bus

Edited by

Fact checked by

Summary:
Tracker funds, also known as index funds, are a popular investment choice for those seeking to replicate the performance of a market index or specific market segments. This comprehensive guide delves into tracker funds, how they work, their advantages, and disadvantages. We’ll also provide answers to frequently asked questions, offering a thorough understanding of this investment option.

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What is a tracker fund?

A tracker fund, often referred to as an index fund, is an investment vehicle designed to mirror the performance of a broad market index, a specific market segment, or even a theme-based index. The primary goal of these funds is to replicate the holdings and performance of a designated index while keeping costs low for investors. Tracker funds can be structured as exchange-traded funds (ETFs) or other alternative investment instruments, and they play a vital role in passive investing strategies.

How a tracker fund works

The term “tracker fund” is derived from the essential tracking function that underlies index fund management. These funds work diligently to replicate the performance of a chosen market index. The introduction of index funds revolutionized the investment landscape by providing investors with a low-cost means of gaining exposure to a wide array of securities included in a market index. The primary advantage of this strategy is the lower expense ratio associated with index funds.
Popular market indexes in the United States include the S&P 500, Dow Jones Industrial Average, and the Nasdaq Composite. These broad market indices have a strong track record of consistent performance, which is why investors often opt for tracker funds. Over time, numerous studies have shown that the majority of actively managed investment funds struggle to outperform these market benchmarks on a consistent basis.
Tracker funds typically come in two main variations: income units and accumulation units. Income units distribute returns to fund holders as cash, while accumulation units reinvest the returns within the fund for further capital growth. This choice allows investors to align their investments with their financial goals and tax considerations.

Special considerations

As financial markets have continued to evolve, investment companies have diversified their offerings to meet the diverse demands of investors. This evolution has given rise to specialized indexes and customized tracker funds designed for specific market segments, sectors, or themes. These specialized tracker funds maintain the objective of tracking a predefined market index while providing investors with more targeted investment opportunities. One of the key advantages of these customized tracker funds is their ability to offer cost-effective solutions, aligning with investors’ specific objectives.
Customized tracker funds follow the same index replication strategy as traditional tracker funds, but they cater to a more specific niche within the market. They typically require significant fund transactions only when a customized index reconstitutes, which generally occurs on an annual basis. These funds offer investors a broader range of options while simultaneously mitigating many of the challenges faced by fund managers attempting to outperform the broader market indices.

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Examples of tracker funds

Investors have access to tracker funds for nearly every market index globally. One of the most popular tracker funds is the SPDR S&P 500 ETF (SPY), with assets under management totaling $364 billion as of June 15, 2021. The fund boasts an impressively low expense ratio of just 0.0945%, making it an attractive choice for cost-conscious investors. Furthermore, the returns of SPY closely mirror the performance of the S&P 500, providing investors with a reliable means of tracking this broad market index.
On the other hand, many investment companies develop their own customized indexes to create specialized tracker funds. For example, the Fidelity Quality Factor ETF (FQAL) tracks a customized index created by Fidelity, known as the Fidelity U.S. Quality Factor Index. This unique index employs a screening methodology to identify high-quality large-cap and mid-cap stocks. As of May 31, 2021, the Fidelity Quality Factor ETF delivered a noteworthy return of 34.2% over the last twelve months, aligning with its focus on high-quality stocks.
It’s important to note that while tracker funds offer many benefits, including cost-effectiveness and simplicity, they may not always outperform the broader market indices they aim to replicate. For instance, the Russell 1000, which represents the U.S. large and mid-cap universe, posted a one-year return of 42.52% as of May 31, 2021, surpassing the performance of certain tracker funds like the Fidelity Quality Factor ETF.
WEIGH THE RISKS AND BENEFITS
Here is a list of the benefits and drawbacks to consider when investing in tracker funds.
Pros
  • Cost-effective way to gain exposure to market indices.
  • Passive management results in lower expense ratios.
  • Customized tracker funds offer targeted investment options.
  • Transparent and straightforward investment choice.
  • Low portfolio turnover may lead to tax efficiency.
Cons
  • May underperform broader market indices due to strict replication.
  • Not suitable for investors seeking active management or stock picking.
  • Returns can be influenced by market volatility.
  • Customized tracker funds may have limited historical performance data.
  • Market evolution may lead to new indexes, making some tracker funds obsolete.

Frequently asked questions

Are there any tax benefits to using tracker funds?

Yes, there can be tax benefits associated with using tracker funds, especially those with low portfolio turnover. Low turnover reduces capital gains distributions, potentially leading to greater tax efficiency in your investment portfolio.

Can I use tracker funds for my retirement savings?

Yes, tracker funds can be a suitable option for long-term retirement savings. These funds offer broad market exposure and typically have low expense ratios, making them cost-effective choices for building a retirement portfolio.

What is the key difference between active and tracker funds?

The primary difference lies in the management style. Active funds are managed by professionals who aim to outperform the market through stock selection and timing. Tracker funds passively replicate market indices and aim to match their performance, making them cost-effective and transparent choices for investors.

Do tracker funds only track stock market indices?

No, tracker funds can also track bond market indices, commodity indices, and various other asset classes. Their versatility extends beyond the stock market, allowing investors to gain exposure to a wide range of financial instruments.

What should I consider when choosing a tracker fund?

When choosing a tracker fund, consider factors such as the expense ratio, tracking error, and the specific index or segment it aims to replicate. Additionally, assess your investment goals and risk tolerance to select the fund that aligns best with your financial objectives.

How frequently do customized tracker funds reconstitute their index?

Customized tracker funds typically reconstitute their index once a year, although the specific frequency may vary. The reconstitution process ensures that the index remains in line with its predefined criteria, offering investors accurate exposure to their chosen theme or sector.

Can tracker funds be used for short-term investments?

While tracker funds can be used for short-term investments, they are better suited for long-term investing due to their passive nature and objective of mirroring index performance. Short-term market fluctuations may have a more significant impact on returns in the short term.

Key takeaways

  • Tracker funds, also known as index funds, replicate the performance of market indices or specific segments.
  • These funds are cost-effective, making them an attractive choice for passive investors.
  • Customized tracker funds provide targeted investment options, catering to specific themes or sectors.
  • Investors should consider factors such as expense ratios and the specific index when choosing a tracker fund.
  • While tracker funds offer advantages, they may not always outperform broader market indices, and their returns can be influenced by market volatility.

SuperMoney may receive compensation from some or all of the companies featured, and the order of results are influenced by advertising bids, with exception for mortgage and home lending related products. Learn more

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