track the underlying market. And one way to invest in a passive fund is through a tracker fund, Phil Oakley explains in MoneyWeek
These tracker funds track an index, like the JSE Top 40. Tracker funds don’t list on the stock exchange, like ETFs for example.
Like unit trusts, you can buy them directly from the fund provider.
So how do tracker funds work?
Well, let's take a JSE Top 40 tracker.
The point of a fund like this is to copy the performance of the JSE Top 40 as accurately as possible. So one option is to buy every share in the index, and reconstruct it that way.
Tracker funds work in three different ways
There are three different approaches…
#1. The full replication approach
Say Woolies accounts for 5.5% of the value of the JSE Top 40. The fund will put 5.5% of its money into Woolies. So if the fund has R1 million to invest, it will buy R55,000 worth of Woolies shares.
Buying 40 stocks from the JSE Top 40 is quite easy and practical.
But when it comes to a much larger index such as the JSE All Share, which has more than 300 stocks, then this approach isn't so good.
The index ranks stocks by size. So by the time you get to the 300th stock on the list that stock is going to make up a tiny proportion of the overall index. And the impact of any move in that stock is so small as to be almost irrelevant.
#2: The partial replication approach
So for large indices, the tracker fund will buy a representative sample of the stocks in the market.
Let's say, general retailers account for about 17% of the All Share Index.
So if the tracker has R1 million to invest, the tracker manager will put R170,000 into general retailer stocks. But he might not buy every single stock in the sector, just the biggest ones.
#3: The synthetic replication approach
This is another way that tracker funds work. These funds use derivatives contracts to match the performance of an index.
That sounds really complicated, but in practice, it just means the fund provider pays an investment bank to give them the same return as the index.
This type of replication does introduce an extra layer of risk – ‘counterparty risk’. This means that the fund is reliant on the investment bank to deliver it the return on the index.
When it comes to buying a tracker fund, you don't have to put in a lump sum all in one go. Most providers should offer you the option of making regular or monthly investments for little or no cost.
So there you have it, what a tracker fund is.