Trackers offer something for everyone
Trackers are excellent products for both private and professional investors who do not want to limit themselves to individual shares and want to spread their risks in a simple, transparent manner, preferably by investing in an entire country, region or sector with just one transaction. Trackers are also a good alternative for price-conscious, active investors. They can be bought or sold at any time during the trading day, and the transaction fees are no higher than the cost of investing in individual shares. Trackers are new in Europe, but elsewhere they have already proved their worth. In recent years they have become extremely popular in the US, where more than 70 trackers, based on a large number of indices, currently represent a total market capitalisation of approximately US$ 60 billion.
Easy, inexpensive and transparent investment in an index
The basic concept of a tracker is simple: it is an investment product that follows an index as closely as possible. This means that the price of a tracker is a continuous, accurate reflection of the level of the relevant index. The price of the tracker is usually only a fraction of the index level, e.g. one tenth or one hundredth of the index. For example, if the French CAC40 index stands at 6000 points, the price of a tracker on the CAC40 index will be, say, ? 60, and if the index rises to 6100, the tracker price will be roughly ? 61. Trackers are passive investment funds, which means that management and research costs are low, since the investment strategy is entirely dependent on the index itself. The only management activity involved is making adjustments to the fund’s portfolio in line with changes to the index. To make the tracker as transparent as possible, the manager publishes the composition and net asset value of the tracker on a daily basis.
Diversified risk, equal profit potential
Trackers have a relatively low risk profile because they follow an index so closely. Indices are made up of a large number of shares (the CAC40 index consists of 40 shares, the Dutch AEX index of 25 shares, the EURO STOXX 50 is made up of 50 shares), and so the risk is diversified. A portfolio that is made up of individual shares can of course achieve the same results. However, it is difficult to spread the risk attached to such a portfolio because this requires a great deal of work and involves high transaction costs due to the fact that so many different shares have to be bought. With trackers, a single transaction lets you buy a piece of the index and makes it easy and inexpensive to profit from the kind of diversification that an index represents.
Dividend
Because a tracker is regarded as a normal share, it pays out dividend. This dividend is derived from the dividends that the investor would have received if the same amount of money had been invested in all the individual shares in the index. The manager of the tracker collects these dividends, subtracts the management fee and either reinvests the dividend or distributes a cash payment at fixed intervals. This can vary from one tracker to another.
Pricing
How closely does a tracker follow the relevant index? Because the shares included in a tracker are the same as the constituent shares in the index and have the same weighting, the price of a tracker follows the index almost exactly. However, since trackers are independently traded exchange products, bid and offer prices also affect price trends. As a result, trackers may sometimes be slightly more or less expensive than the index. The more trackers that are traded, the narrower the spread will be between bid and offer prices and the closer the tracker price will be to the index level. The fact that some market parties will also take advantage of the arbitrage potential of trackers also ensures that difference between the tracker price and the index remains small. (Professionals can use trackers for arbitrage purposes in combination with baskets of shares or derivatives based on share indices.)
The structure of a tracker
Technically, a tracker is an exchange-traded investment fund. The fund manager’s task is simply to follow the index, and hence the investment policy is passive. Notably, the fund manager only creates new trackers if a market party has delivered a basket of shares that is identical to the composition of the relevant index. Conversely, trackers can be redeemed if a party delivers trackers to the fund manager in exchange for the underlying basket of shares. In combination with exchange trading in trackers, this creation/redemption mechanism provides considerable opportunities for arbitrage using trackers and the underlying basket of shares.
Strategies using options and futures
Trackers can be combined with options and futures on the same underlying index. For example, an investor can write calls on the AEX index options and hedge them with a corresponding number of AEX index trackers. Conversely, investors can use options or futures on the AEX index to protect their investment in AEX index trackers.
NextTrack
With the launch of NextTrack, Euronext, the biggest exchange in Europe, has created a special market place for trackers. Existing trading systems will handle the trade in trackers: TSA (Trading System Amsterdam) in the Netherlands and NSC-VE (Nouveau Système de Cotation) in France. In mid-2001, all securities, including trackers, will be transferred to NSC-VE. Euronext and the institutions that issue trackers (banks and asset management firms) will actively support this new investment product. Their support will include a series of marketing activities and investor information campaigns. Euronext guarantees that its transaction and listing fees will be competitive and that its website will continue to provide extensive information about this exciting new product.
