Find out how index tracker ISAs (individual savings accounts) work and learn about the three ways trackers track indices and the different buy and sell situations an index tracker ISA faces.
An example of how index trackers work
An index tracker attempts to match the performance of a particular 'index' of shares. In other words, it attempts to grow as closely as possible to the growth rate of that index of shares. It does this by exposing itself to the performance of the shares in that index. To keep things simple, let's imagine that the following are the biggest five companies on a theoretical stock market and that we want to create an index of them. (For those who hate maths, dig out your old game of Monopoly and use the paper money to represent our theoretical index so you can easily track the various explanations.)
| Company |
Share Price |
Shares in Issue (millions) |
Market Capitalisation (£m) |
| Allied Pharma |
1600p |
10,000 |
160,000 |
| British Banking |
500p |
20,000 |
100,000 |
| Cable Telecoms |
800p |
10,000 |
80,000 |
| Deep Hole Mining |
100p |
40,000 |
40,000 |
| Exploration Oil |
1000p |
2,000 |
20,000 |
| Total |
|
400,000 |
The market cap or market capitalisation is the figure for the total value of all the shares in each company. It is therefore the sum of the value of every shareholder's shareholdings so £400 billion is therefore the sum total of every pound invested in these five companies.
Two types of index: weighted and unweighted
There are basically two types of index that people might try to make out of this: weighted and unweighted. An unweighted index would give equal weight to the movements of each company. Each company would make up one fifth of the index. So, one fifth of the index's percentage movement is accounted for by each share. If Allied Pharma goes up 10 per cent, then the index will rise 2 per cent. If Exploration Oil moves up 10 per cent, then the index will also rise 2 per cent. If both Allied and Exploration rise 10 per cent, then the index will rise 4 per cent. If one rises 10 per cent and the other falls 10 per cent, then the index will be unchanged. Of course, if all the shares in the index rose 10 per cent, then the index would rise 10 per cent.
A weighted index gives different weights to the effect of each share's movement on the index according to how big the company is (by market cap. or total money invested). Allied Pharma, with a market cap. of £160 billion, makes up 40 per cent of the index (that is, 160 divided by 400). So, if its shares rise 10 per cent, the index will rise by 4 per cent. Exploration Oil, on the other hand, only accounts for 5 per cent of the index. A 10 per cent rise by Exploration therefore only has a 0.5 per cent effect on the index. In other words, movements in Exploration Oil's share price only have an eighth of the effect on the index that movements in Allied Pharma's have. This is because Exploration is only an eighth of the size, and only has an eighth as much money invested in it.
The important thing about weighted indices is that they reflect the average performance of every pound in the index. You can think of a weighted index as being like a portfolio which owns all the shares in all the companies. Whatever happens to the share price of the companies in the index, a weighted index matches the performance of the average pound invested in it.
Why most trackers are weighted
Anyway, the point of all this is that if we want a tracker which gives us the average performance of the market as a whole (which we do) then, for starters, we need to be tracking a weighted index. For this reason, the majority of indices are weighted. Examples from the UK include the FTSE 100, the FTSE 250, the FTSE 350 and the FTSE All-Share. In the US, there is the S&P 500.
The exception: the Dow-Jones
Perhaps the most famous index in the world, the Dow-Jones Industrial Average, is an unweighted index. Other unweighted indices are the FT 30 in the UK and the Nikkei 225 in Japan. Tracking these (unweighted) indices would not (necessarily) give you anything like the average performance of the US, UK and Japanese stock markets and would therefore be a fairly pointless exercise. So that's how an index is put together. Now let's look at how a tracker goes about tracking its chosen index.
How does a tracker track?
There are three basic ways that a tracker tracks an index: full replication, statistical sampling, and use of derivatives.
Full replication
This is the most straightforward method of tracking an index. It involves simply creating a portfolio which includes all the shares in the index at their relevant weights. So, if you were setting up a tracker fund with £4 million to track the performance of the theoretical weighted index that we looked at above (which we'll call the TMF 5, standing for 'The Motley Fool 5'), then we would need to buy 0.001 per cent of each company (that is, our fund of £4 million divided by the total value of the index of £400 billion). So, we'd buy the following:
| Company |
Share Price |
Shares Purchased |
Value (£) |
| Allied Pharma |
1600p |
100,000 |
1,600,000 |
| British Banking |
500p |
200,000 |
1,000,000 |
| Cable Telecoms |
800p |
100,000 |
800,000 |
| Deep Hole Mining |
100p |
400,000 |
400,000 |
| Exploration Oil |
1000p |
20,000 |
200,000 |
| Total |
|
4,000,000 |
Once we've bought these shares, then all things being equal, we can just leave the tracker to do its job. We basically only have to buy and sell the shares in three situations.
Index changes
The TMF 5 is designed to follow the performance of the average pound invested in the five biggest companies on our theoretical stock market. So, if Exploration Oil shares did badly and it was overtaken, in terms of market capitalization, by Future Technologies plc whose shares have recently been doing well, then Future Technologies would replace it in the TMF 5 Index. We would therefore have to sell all our shares in Exploration Oil and buy, instead, shares in Future Technologies (we might also have to tinker with the overall weightings of all the stocks if our correctly weighted stake in Future costs more than we get for our Exploration shares).
Share capital changes
This is when the member companies issue new shares or cancel any of their existing shares. Imagine that Deep Hole Mining issued 1 new share for every 4 of its existing shares to buy the Australian company, Gold Diggers Pty Ltd. The TMF 5 would have to reconstitute itself to take account of this. Assuming that the market was ambivalent towards the deal and the share price of Deep Hole didn't move, the new index would look like this:
| Company |
Share Price |
Shares in Issue (millions) |
Market Capitalisation (£m) |
| Allied Pharma |
1600p |
10,000 |
160,000 |
| British Banking |
500p |
20,000 |
100,000 |
| Cable Telecoms |
800p |
10,000 |
80,000 |
| Deep Hole Mining |
100p |
50,000 |
50,000 |
| Exploration Oil |
1000p |
2,000 |
20,000 |
| Total |
|
410,000 |
So all the other companies' weightings have fallen (Allied Pharma's weighting has fallen from 40 per cent (160/400) to 39.0 per cent (160/410)), while Deep Hole's weighting has increased (from 10 per cent (40/400) to 12.2 per cent (50/410)). As a result, a little of each of the other companies will need to be sold and the money used to buy shares in Deep Hole.
New money from investors
The third reason for buying and selling would be if a new investor came along and asked to invest £100,000 in the tracker fund (or if an existing investor decided to withdraw £100,000 from the tracker). In this case, we would have to add 2.5 per cent to (or sell 2.5 per cent of) the value of each of our holdings. This is happening all the time with most index trackers (other than the investment trusts). Every day, people are coming along to put more money in or to take money out. If there is a pound put in for every pound that gets taken out, the balance is maintained. However, if, overall, money is flowing into the fund, then it will need to be buying shares in each company each day to maintain its correct exposures. If there is net money flowing out, then it needs to be selling shares in each company each day to maintain the balance. All this buying and selling costs money and it is mostly borne by the new or departing investors in the form of the "bid/offer spread" on buying new units.
The main advantage of the full replication tracking approach is that you can expect to match the index very closely. The disadvantage is that it can be expensive and it is only really very practical where you have a relatively small number of shares in an index. The FTSE 100, with its 100 member companies, lends itself reasonably well to this.
Statistical sampling
With an index like the FTSE All-Share (which has around 800 member companies), full replication is likely to be extremely costly to achieve. To track these larger indices, most fund management companies will therefore use a process called statistical sampling. The fund doesn't try to hold every share in the index, but it analyzes the index and works out its investments so that it is very confident of achieving a performance very close to it.
So, at a basic level with the TMF 5 we might decide that, since Exploration Oil only accounts for 5 per cent of the index's value, then we don't actually need to hold it to ensure a performance very close to the index. We do, though, have to keep a close eye on it. If it increases by 20 per cent relative to the rest of the index, then we will underperform by 1 per cent and we certainly don't want to risk underperforming by more than that. We might therefore decide that we can afford to save costs by not holding Exploration unless and until it increases to a level where it accounts for 6 per cent of the index. Of course, if Exploration underperformed the rest of the index then we would benefit from not holding it.
Statistical sampling is a bit of a fudge. If money flows into the fund from new investors, shares of one sort or another will certainly have to be bought, but we might be able to save a bit on costs by not sticking rigidly to buying exactly the right amount of every single company. With a large index such as the FTSE All-Share, the relationships between the different shares will be examined, so that the tracker's manager can be very confident of not departing very far from the index. Of course, some companies will be good at this and others bad. To have the same range of likely performance compared to the index, it might cost one company less than another. Unfortunately, few trackers have a long enough track record for us to work out who's good and who's bad. It's probably not a bad idea, then, to stick with the more established fund management companies who have good experience of this sort of thing. Pound for pound, it is also probably cheaper for the larger funds to do all the sums needed for this method.
Use of derivatives
Finally, a tracker might use things called 'derivatives' to match the performance of an index. For instance, it might leave all its investors' cash in the bank and use it as the collateral for a futures contract on the performance on the relevant index. By buying the right derivatives, a fund can organize things so that its performance will reflect the performance of an index very closely.
One advantage of doing things this way is that money coming into the fund just goes into the bank. In the same way, when people take their cash out, it can simply be paid out of the bank. This might be a lot simpler than having to buy or sell all of the shares every day (or a representative sample of them). However, the fund manager would still need to increase or reduce the level of exposure the fund has to the index each day, and there will be costs associated with this.
A fund might combine using derivatives with some form of statistical sampling. By buying an underlying level of derivatives exposure, the fund might be able to reduce costs in the buying and selling of the actual stocks that it needs to top up its exposure.
Call us old fashioned but, despite some potential for cost savings, we Fools don't really like the sound of trackers using derivatives. We're sure they're all very careful, but then everyone was sure that Barings Bank was very careful until it went bust. Insuring against problems would just increase costs and, to us, it looks like yet another case of it being best to keep things simple.
Back to main ISAs page »
