Trackers: letting an index do the work

There's a world of difference between the traditional City investment house and the new faces on the investment scene such as Direct Line, Marks & Spencer and Virgin Direct.

The newcomers offer tracker funds that follow the performance of a specific stock market index, usually the London stock exchange. A number of established managers have also entered the fray, offering trackers alongside their traditional actively-managed funds.

Together, these new-style funds have attracted pounds 3bn of our money following a simple proposition: as long as shares are rising, an index-tracking fund will follow.

Not all trackers are the same, however. The differences lie in the index followed and the method used to do so. Several funds, including the Direct Line PEP, follow the FT-SE 100 - the Footsie. One of its key attractions is its familiarity, according to Robert Allen, investment products manager at Direct Line: "The Footsie is well known; it's mentioned in the news most days and even papers like the Sun chart its performance."

In contrast Virgin follows the FT-A All Share index, which includes more than 900 shares, which means greater diversification, according to Tony Wood, marketing director of Virgin Direct. While it would be easier and cheaper to track the Footsie, investors could miss out on higher potential returns.

The other difference between funds is how they choose to match the market. Some managers, such as Legal & General and Gartmore, invest in just a few shares to try to match the whole market. The shares are chosen on an historical basis - those which have in the past best matched the market performance. However the wrong stock selection can leave these trackers way off the index.

That is why many managers go for full replication of their chosen index, which means holding shares in every listed stock. This is the approach taken by both Direct Line and Virgin.

Following the market upwards sounds attractive, but what happens when it falls? The active managers claim that while a tracker will inevitably slide, they (backed by their detailed research) will be able to select shares that will not fall as fast as the market, or even ones that do not slide at all.

Mr Wood's reaction is swift and to the point. "It sounds like a perfectly sensible, if rather desperate theory. The trouble is that while tracking funds will indeed follow the market down, actively-managed funds have generally fared no better in falling markets than rising ones."