If you think the outlook for the UK economy is looking very bright you might want to buy exposure to the UK stock market. Instead of buying single stocks an increasingly popular alternative is to buy the whole market through an exchange-traded fund. One of these tracker funds can track indices like the FTSE 100 very cheaply. So what do we need to consider when we buy one of these funds? Well there are three factors: the first one is the fees you pay, the second factor is fees and the third factor... is fees.

Of course I'm being facetious - there are other factors you have to consider so let's look at those factors in detail.

This is not a recommendation. If you're thinking about buying an ETF seek independent financial advice.

Market Capitalization

The job of an ETF is very simple, all it has to do is track an index. The job of the fund manager is to copy the returns of an index, and this is a simple, almost mechanical process that requires no expert views on the future. A useful analogy is driving along tracks left in sand. All the driver has to do is steer along the track. But the question is which track do we follow? There are several UK stock indices and they're grouped according to something called market capitalization so let's just take a quick look to see what that means.

Firstly let's consider a small company, Flybe. Instead of looking at the price of a single stock we'll look at the price of all of its stocks. So we will take the number of shares, Flybe's got about 217 million shares, and we multiply by the price per share. The product of the two is called the market capitalization or the "market cap" and for Flybe that's very small, it's just 88 million pounds. Now let's look at a really large company, let's look at Royal Dutch Shell. It has over 8 billion shares and they're worth 20 pounds and 80 pence per share. Multiply the two together and you get the market cap of £170 billion. So the range of market cap for the London Stock Exchange runs from about a hundred million to about two hundred billion.

London Stock Exchange market capitalization ranges from £100 million to £200 billion

As prices fluctuate during the day the market cap will change so when you come to look at these numbers they'll be quite different, but the reason why we introduced market cap was because that's how stock indices are organized - according to the capitalization of the companies in the index, ranging from large cap to small cap.

What UK indices are on the menu?

The hundred largest companies on the FTSE 100 [London Stock Exchange] by market cap go into the FTSE 100. The next 250 largest companies go into the FTSE 250. And the 351st to the 619th largest companies go into the FTSE SmallCap. There's also the FTSE 350 which combines all of the stocks in the FTSE 100 and the FTSE 250. And the FTSE AllShare which combines all three.

Benchmark and Tracking Error

So now we know what we're tracking what's the objective of the tracker? It has to match the performance of the index. If the index increases by 1% the price of the tracker also increases by 1%. If the index falls by 1% so does the tracker.

If you look at the information documents for many of the trackers you'll see a graph that looks like this. In green it shows the performance of the fund since April 2000. The index that it's attempting to track is called the benchmark, in this case it's the FTSE 100. The tracking will never be perfect, and you'll see that the two lines above diverge over time because there's a cumulative tracking error. In a perfect world tracking error would be zero, but the best we can hope for is that the tracking error remains small.

In a perfect world tracking error would be zero​

So the name of the game is tracking and for the FTSE 100 we're tracking large companies. Now because these companies have a large market cap they're very liquid stocks. That means the difference between the buying price and the selling price is very small and for the fund managers running these ETFs that means they can track the index very cheaply. Also there's no thinking involved. We're not trying to beat an index we're just trying to copy it. And the cost of these passive funds, as they called, is much lower than active funds. So all of these factors together mean that we should expect super low fees.

Measuring Ongoing Fees: Total Expense Ratio

How do we measure the fees? Well we use something called Total Expense Ratio, or TER, and what we're paying for is the management fee for the fund manager but also any kind of expenses which they incur running the fund will be passed on to us. And it's expressed as a percentage of the Net Asset Value of the fund.

What does TER mean for you? Well if you invest ten thousand pounds and the TER is one percent then every year you'd pay one percent of ten thousand or one hundred pounds per year.

Comparing FTSE 100 ETF Tracker Fees

You can see that there are eight funds which track the FTSE 100. The column you should be looking at is the Total Expense Ratio. You can see that's well below one percent. For the cheapest fund, which is ISF, it's only 0.07%. Another column you might find interesting is the NAV which is the size of the fund. NAV stands for Net Asset Value and you can see that for ISF it's £4.7 billion.

There are two trackers from iShares here: ISF and CUKX. One of them pays you a dividend every quarter: that's ISF. The other one, CUKX, accumulates the dividend as part of the fund as if you'd reinvested the money back into the fund. But both of them have exactly the same Total Expense Ratio of 0.07%. That means that if you invest ten thousand pounds you'd only be paying seven pounds per year in management fees, which is reason to be very happy.

If we actually look at the composition of the FTSE 100 you can see that there are lots of banks, lots of energy companies and lots of pharmaceutical companies many of which are multinational. You'll often hear people say that the FTSE 100 is not really a UK index at all, instead it's a global index because although all the stocks are listed on the London Stock Exchange they generate most of their revenue outside the UK. It's said that if you want more exposure to the UK domestic stock market you would buy the FTSE 250 but, in fact, it's not quite as simple as that.

FTSE 250 not just UK domestic stocks

This is a 2014 article from the Morningstar website by Hortense Bioy. It makes the point that 15 percent of the holdings of the FTSE 250 is made up of investment trusts and the exposure of those investment trusts is global so it's misleading to think of the FTSE 250 as a purely UK domestic index.

Fortunately there are several FTSE 250 trackers, you can see six of them here. But you'll also see there's no FTSE SmallCap ETF tracker, there are no FTSE 350 ETF trackers and there are just two FTSE AllShare trackers.

Here are the six FTSE 250 trackers. Vanguard's fund is the cheapest with a Total Expense Ratio of just 0.1%. The iShares fund is much more expensive: its TER is 0.4% per year.

So there was your quick overview of the trackers for the UK stock market. Maybe you don't invest in ETFs at all, perhaps you prefer investment trusts? If that's the case please tell us we'd love to know!

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