Tracker Funds

A tracker fund, also known as an index fund, mirrors the performance of a broad market index or a segment of it.
Tracker Funds
3 min
07-June-2024

Tracker funds, also referred to as index funds or passive funds, are investment vehicles crafted to mimic the performance of a specific financial market index, like the S&P 500 or the FTSE 100. By holding a portfolio of securities mirroring the index's composition, these funds aim to replicate its returns.

What are tracker funds?

A tracker fund’s meaning, in basic terms, refers to any index fund that regularly tracks a wide market index or even a segment of it. Tracker funds also expose investors to the entire index at a relatively lower cost. Moreover, such funds replicate a designated index’s performance and holdings, constructed as alternative investments or ETFs for meeting the tracking objective of the fund.

Thus, tracker funds are pooled investments that replicate market index performances.

How do tracker funds work?

Tracker fund, as a term, has evolved from tracking functions that drive the management of index funds. Investing in index funds amounts to passive investing. Index funds were initially introduced to help investors access low-cost investment vehicles to get exposed to a plethora of securities included in a market index, and its most important advantage is a low expense ratio.

The most popular indices in the Indian market are the S&P BSE Sensex and Nifty 50. Investors generally choose conventional tracker funds since most investment fund managers fail to consistently beat the broader market indices.

Most tracker funds are available as either accumulation units or income. The income is paid to fund holders in cash, and for accumulation unit holders, it is retained for reinvestment in the fund.

With markets evolving over time, most investment companies have been meeting the demands of investors by developing more innovative indices and funds. Consequently, many such investment companies have been working with index providers or have even created customised indices for use in funds that are passively managed.

Examples of Tracker Funds

Some examples of tracker funds include:

  • Old Mutual MSCI World ESG Index Fund: This fund invests in multinationals recording the highest performance in environmental, social and governance (ESG) while tracking the MSCI World ESG Leaders Index.
  • Fidelity Index World Fund: This fund invests in about 1,600 companies worldwide including Toyota, Netflix, and Amazon, and follows the MSCI World Index’s performance closely.
  • Legal & General Global Health & Pharmaceuticals Index: This fund invests primarily in the healthcare sector globally and tracks the performances of pharmaceutical, biotechnology, and healthcare companies like Pfizer and Johnson & Johnson that fall under the FTSE World Index.
  • Legal & General Global Technology Index: This fund tracks the FTSE World Index under which companies that have pioneered some major digital trends in the world, like Microsoft, Apple and Google, fall.
  • Fidelity Index Emerging Markets Fund: This tracker fund monitors companies that are growing in emerging markets such as Latin America, Africa, and Asia on the basis of their long-term growth. The fund makes investments in several sectors, including retail and technology, including companies such as Alibaba, Tencent, and Samsung.

Advantages of tracker funds

The key advantages of tracker funds are as follows:

  • Diversification: A much broader market exposure minimises most risks that come with individual stocks.
  • Low costs: The investor enjoys the privilege of lower operating expenses and management fees owing to passive management.
  • Transparency: Holdings are predictable and known since they reflect a certain index.
  • Performance: Tracker funds typically match market performances. Thus, they avoid the pitfalls usually associated with active managers who underperform.
  • Simplicity: These funds are easier to manage and understand, making them ideal for novice investors.
  • Tax efficiency: Lower rates of turnover result in lesser capital gains taxes.

The abovementioned benefits make tracker funds a fairly attractive investment option for many who seek straightforward and efficient investment solutions.

How to invest in tracker funds?

Investing in a tracker fund is fairly straightforward. The investor chooses a specific index, and a fund that replicates that index is subsequently selected. This requires comprehensive research of the fund’s past performance and fees.

Following this, an investment account needs to be opened with a financial institution or brokerage offering access to the fund. The investor then deposits the money into their investment account to buy shares or units of the tracker fund they have selected through their brokerage account. Once the investment formalities are done, they need to monitor their investment regularly to ensure it always aligns with their financial goals.

Special considerations for tracker funds

Although index or tracker funds offer several advantages, investors must also consider certain aspects before making a decision.

  • Market exposure: A tracker fund provides a broader market exposure, which also implies that it inherits the risks associated with the market. During downturns, tracker funds reflect the market’s decline and offer no protection against losses.
  • Tracking error: Even though a tracker fund aims to replicate an index’s performance, discrepancies may occur. This difference, also called a tracking error, may arise from several factors, such as trading costs, fees, and dividend reinvestment timing. A lower tracking error indicates a closer alignment with the index.
  • Dividend reinvestment: Dividend handling is known to vary among tracker funds. Some funds reinvest dividends automatically, whereas others distribute them to their respective investors. Hence, understanding the dividend policy of the fund beforehand is crucial to align with the investor’s investment strategy.
  • Management fees: Although tracker funds' fees are lower than those of actively managed funds, they can impact the overall net returns over time. Thus, it is essential to compare fees across several tracker funds to optimise cost efficiency.
  • Limited flexibility: Every tracker fund adheres to its benchmark index rigidly and, therefore, lacks the flexibility to respond to changing market conditions. This is a disadvantage during times of volatility or when certain sectors within the ambit of the index underperform.

Disadvantages of tracker funds

The notable disadvantages of tracker funds are as follows:

  • Non-flexibility: Tracker funds cannot adjust their holdings to respond to emerging opportunities or market conditions.
  • Market risk: They reflect the entire index’s performance, resulting in losses during market downturns.
  • Dividend-related issues: Variations in handling dividends may affect net returns; some funds distribute their dividends, whereas others reinvest.
  • Tracking error: Even negligible deviations from the index may impact returns (albeit minimally).
  • Potential underperformance: In a bull market, an actively managed fund may outperform a passive tracker fund owing to its strategic selection of stocks.

Taxability of tracker funds

Tracker funds are also subject to taxation, and an investor may incur taxes on the following:

  • Dividends: Any dividend received from underlying stocks that the tracker fund holds is taxable.
  • Capital gains: The profit earned by selling shares of a tracker fund is taxable at capital gains rates.
  • Tax efficiency: Tracker funds usually have lower turnover rates, which results in fewer taxable events, making them more tax-efficient than actively managed funds.
  • Reinvested dividends: All reinvested dividends are subject to tax.

Thus, knowing the tax implications that come with tracker funds beforehand is critical to efficient tax planning and optimising post-tax returns.

Passive vs. active investments in tracker funds

Let us now compare passive and active investments in tracker funds.

Active investments

  • Higher costs: An active investment usually comes with higher trading costs and management fees, owing to all research and analysis-related activities involved.
  • Expertise of fund managers: Active investments always involve fund managers who actively select and manage securities to outperform the market.
  • Potential outperformance: Active investments try to outperform the market by capitalising on market inefficiencies and by exploiting available opportunities.
  • Tactical adjustments: A fund manager has the flexibility to tactically adjust the portfolio on the basis of investment strategies and market conditions.

Passive investments

  • Lower costs: A passive investment typically comes with relatively lower operating expenses and management fees as compared to an actively managed fund.
  • Replication of the index: Passive investments typically replicate a specific index’s performance.
  • Market efficiency: Passive investments generally assume that markets will remain efficient, and it is challenging to consistently beat the market in the long run.
  • Minimum human intervention: Passive funds need minimum human intervention since they operate on predetermined rules for mirroring the index.
  • Diversification: These investments offer broader market exposure to provide the benefits of diversification across several asset classes and sectors.

Conclusion

Tracker funds (or index funds) that are passively managed include indices customised for sectors, themes, and market segments. Additionally, strategies for successfully operating tracker funds have expanded beyond conventional value indices and growth and now include indices used for a much wider class of fundamentals and characteristics. Even though tracker funds work by tracking a predefined market index, they offer relatively lower returns to investors. However, they manage to get many benefits associated with the management of active funds through carefully screened indexes.

Moreover, market innovations have increased the potential for a majority of customised tracker funds, consequently attracting more targeted investments. Thus, when answering the question, ‘What is a tracker fund?’, it can be inferred that a tracker fund is a financial instrument created to track or match the market index price, and investing in such a fund exposes the investor to several financial assets such as bonds and shares, without buying them directly.

If you are an investor and want to start your investment journey, you can visit the Bajaj Finserv Mutual Fund Platform to learn more about mutual funds and SIPs. You can also use the lumpsum calculator and SIP calculator to strategise your investments.

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Frequently asked questions

How does a tracker fund work?

Tracker funds provide investors with cost-effective and simple ways to get exposure to specific markets or sectors by reflecting an underlying index’s performance. Investors who seek diversified and low-cost investment options tend to favour such funds.

What is the difference between an ETF and a tracker fund?

While tracker/index funds and ETFs track underlying index performance, they are different in terms of their trading flexibility, structure, tax efficiency, costs, and accessibility.

What is a tracker fund in India?

A tracker fund is an index fund. Such funds aim to replicate the performance of a pre-determined stock market index, such as the Nifty 50 or BSE Sensex. Indian tracker funds function similarly to other index funds operating worldwide and offer investors the advantage of being exposed to a highly diversified portfolio comprising securities that reflect the chosen index’s composition.

What is a tracker pension fund?

Also called a passive pension fund, a tracker pension fund invests its assets by closely replicating a certain financial market index’s performance. The structures of such funds are similar to index or tracker funds. However, they are tailored specifically for pension-related investments.

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Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

This information should not be relied upon as the sole basis for any investment decisions. Hence, User is advised to independently exercise diligence by verifying complete information, including by consulting independent financial experts, if any, and the investor shall be the sole owner of the decision taken, if any, about suitability of the same.