Fund Focus: the big tracker fund problem

Index funds and exchange-traded funds (ETFs) have done a roaring trade in the last decade, resulting in plenty of competition on fees and plenty of scrutiny on what such funds hold. 

Both trends are relevant to this week’s column. 

That’s especially the case when we consider recent debate about the launch of the Vanguard FTSE Global All-Cap ETF USD Acc GBP (LSE:VALL) in August, and whether investors should switch from existing global trackers into this fund. 

Why such heated discussion? 

The fund certainly lays down the gauntlet to competitors on the price front, given it charges a fee of just 0.07% a year.  

But investors wonder whether it would give the same exposure as, say, as FTSE All-World tracker, given that the fund claims to have a focus not just on the world’s largest companies but small and mid-cap shares too. 

Vanguard has not disclosed how much exposure the fund has to smaller companies, and I can’t find such information from the provider of its underlying index either.  

But a glance at past returns from the FTSE Global All-Cap index it tracks versus the FTSE All-World points to almost identical performance. 

This suggests that the former is still dominated by large-cap shares, and that the presence of smaller companies is limited to say the least. 

That might come as reassurance to those who have been mulling whether to deploy new cash into VALL as a way of getting cheap exposure to global markets. 

But it also reminds us of a gaping hole in many a “broad” tracker fund. 

Big beasts 

Those who follow markets and use tracker funds to invest in them will be familiar with a common moan: that the US market (and in turn many a “global” one) is dominated by just a handful of companies. 

When such companies dominate returns, many other parts of the market are overshadowed. 

This might be something we just accept. 

But it’s worth remembering that in practice small and mid-cap companies are not so well represented in many tracker funds that would appear to cover the whole market. 

And anyone using such a fund is not necessarily as diversified as they hope. 

VALL is just one fresh example of this trend, but it’s not limited to US and global indices. 

To find another example we simply need to turn to our home market. 

Consider the table below, which maps out the performance of the FTSE 100, the FTSE All Share, the FTSE 250 and the FTSE Small Cap over some standard investment timeframes. 

With UK large-cap shares having a moment in the sun, we have seen the FTSE 100 pull ahead of the broader FTSE All-Share over five years. 

But if we look at the other timeframes the two have pretty much identical returns. 

This has big implications if, like many an active UK equity fund manager, you see small and mid-cap shares as undervalued after an unflattering run of performance.  

A FTSE All-Share tracker will tend to capture the wins of the FTSE 100, but will not necessarily participate that fully in a rebound for small and mid-cap shares, if we do see one emerge. 

As such investors might want to branch out on this front – be it by using a dedicated tracker like the Vanguard FTSE 250 ETF GBP Acc (LSE:VMIG), by backing some of those fund managers delving in the small and mid-cap space, or even directly buying shares in this universe. 

As a reminder, small-cap shares in particular can be a risky prospect. 

And this problem can crop up in other markets. 

One obvious example would be in the emerging markets, where three big names, Taiwan Semiconductor Manufacturing Co Ltd ADR (NYSE:TSM), Samsung Electronics Co Ltd DR (LSE:SMSN) and SK hynix Inc ADR (NASDAQ:SKHY), have done much of the work in the powerful rally of the last year or so. 

Emerging market ETFs can be enormously diversified, with the iShares Core MSCI EM IMI ETF USD Acc GBP (LSE:EMIM) having almost 3,000 holdings. 

But TSMC alone makes up around 13% of the portfolio, with Samsung and SK Hynix accounting for around 12% between them.  

That leaves less room for small and mid-cap companies to make an impact on return. 

It should be caveated that this problem won’t apply to every market. 

Indices focused on Europe tend not to see its biggest constituents take up too much space, meaning your source of returns could be broader. 

But it’s another reminder that trackers are not always as diversified as we think – and to build out your portfolio accordingly.  

If small and mid-cap shares do close the gap with their bigger peers, the most widely followed passive funds may not see much of the benefit.