The physical tracking structure is the norm in the US market, and as an investor in the UK you can also take advantage of this big investing idea, which is as easy as investing in an ordinary share but with less risk. The concept of holding the underlying, physical assets is simple to understand, even though the details of how it works – which you fortunately don’t need to concern yourself with – are a bit more complicated.

Physical tracking means that if a particular share is in the index, the fund managers make sure that those physical shares are also in the fund; that is, they buy the underlying assets, be they stocks, bonds or silver nuggets.

In essence, you’re buying into a fund that copies the index by buying the stocks (or bonds for that matter) within your chosen index. As that index changes in composition on a daily basis, so do the holdings of the fund. All this for 0.10 per cent in charges: bargain!

In general, tracking major developed-world markets such as the S&P 500 is best done on a long-term buy-and-hold basis using physically replicating ETFs; they’re cheap and do exactly what they claim.

Physical replication is fine and dandy if you’re tracking a broad, liquid, well-known index such as the S&P 500, where tens of thousands of professional institutions operate on a real-time basis.

But some indices aren’t as liquid or efficient. Sometimes there are complications and errors that can occur with specialised indices. (Note: Although these types of issues can happen with all indices, it’s a bigger problem with more specialised indices.)

Complications related to specialised indices

Unlike general indices, specialised indices may track, for instance, Indian shares or a specialised sector of the US mainstream equity space such as small-cap US stocks that pay a high yield. Within these specialised indices all manner of complications arise, including:

  • A small number of underlying stocks.

  • More illiquid stocks, with wider bid–offer spreads.

  • An illiquid market that hampers the fund manager’s ability to buy the underlying stocks.

  • Varying tax treatment of dividends, depending on the tax jurisdiction.

So physically tracking a specialist index can be a tad more complicated than tracking the S&P 500. This needn’t prevent a fund provider from setting up an ETF, but their management costs may be a little higher.

Index tracking errors

Tracking errors can also emerge, which involve a discrepancy between the returns from the underlying index against the returns from the fund. Tracking errors can amount to as much as 1.5 per cent a year. They may emerge for a whole bunch of reasons, not least those bigger management fees, and their effects can be drastic.

You may think that your ETF is tracking an index and should return 5 per cent this year, but in fact the fund returns only 3.5 per cent. So the tracking error is 1.5 per cent.