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Index trackers have become an investment staple since the first exchange-traded fund, the SPDR S&P 500 (NYSEARCA:SPY), was launched by State Street Global Advisors in 1993. The market has grown exponentially since then, and the three largest providers of S&P 500 trackers (State Street, Vanguard, and iShares) have a total of $335 billion in assets. There are now thousands of ETFs offered globally, many of which are designed to track equity indexes.

In the U.K., some of the popular equity index trackers include ISF.L (FTSE 100 tracker) and MIDD.L (FTSE 250 tracker), which are managed by iShares. They have around $4.2 billion and $1 billion invested in them, respectively. Combined, these two ETFs are about the size of FTSE 100 companies such as easyJet (OTC:EJTTF) or Whitbread (OTC:WTBCF).

Readers should note that although I am writing mainly from a U.K. index tracker perspective, the analysis is generic and the principal is equally valid wherever index tracker ETFs are designed to follow any market capitalization index -- e.g., SPDR S&P 500, PowerShares Nasdaq (NASDAQ:QQQ), and SPDR Russell 1000 (NYSEARCA:ONEK). Index trackers have many advantages that have contributed to their popularity. They generally have low costs (annual charges on ISF.L and MIDD.L are 0.4%), can be tax-efficient, are liquid, and trade in the same way as an equity on an exchange.

There are also disadvantages. The main problem with index trackers lies with the index itself. Most equity indexes are market capitalization indexes, which means the larger companies dominate their level and their price movements drive the changes. The largest 22 companies account for two-thirds of the FTSE 100 index. So the 78 remaining companies, many of which are dynamic with high growth potential, are having a negligible effect on the overall index. Every time you buy a FTSE 100 tracker fund, you are effectively buying the 100 largest U.K. companies in direct proportion to their size.

The FTSE 100 is dominated by three sectors, totaling 40% of the entire index: oil/gas (15.7%), banks (15%), and mining (9.2%). So you are inadvertently exposing yourself to the fortunes of the largest companies and sectors, which may be overvalued. Therefore, the tracker may not be well-diversified. Furthermore, this lack of diversification can get worse over time -- especially in rising markets when the largest stocks are getting overbought.

A good way to illustrate this is to look back over the past 12 months at two portfolios: Portfolio A is the FTSE 100 iShares ETF, which we assume is exactly tracking the index. Portfolio B contains all 100 FTSE 100 stocks in exactly the same proportions as the tracker on Oct. 1, 2012, and left untouched for a year until Sept. 30, 2013.

Click to enlarge images.

So Portfolio B (left alone) outperformed the FTSE 100 Index tracker by over 5% over the last year. The majority of this is attributed to the fact that the diversification of the index is degrading over time and becoming more concentrated in the overbought stocks and sectors. This example is a simple way of showing that if we are clever about how we select and weight a portfolio, then we can achieve significantly better returns than the index even though we are using the same universe of stocks.

In 2011, economics Professor John Kay of Oxford University and the London School of Economics was commissioned by the U.K. government to conduct a review of U.K. equity markets. One of the key findings of the Kay Review was that there is an intrinsic problem with investing in tracker funds because of the heavy skew toward the dominant sectors and companies, and the lack of diversification:

Index funds are necessarily overweight in overpriced sectors and underweight in underpriced sectors and this is true even if one has no knowledge of which sectors are over or underpriced. Holding a wide range of stocks is not the same as holding a diversified portfolio.

Kay's report goes on to comment on managed funds, which are the only real alternative to passive tracker funds. The majority of these funds, he argues, are no more than "closeted" index trackers whose investment strategies tend to follow market indexes. Again, the average investor would have no real idea about this.

So it's clear that investors are better off with investments that are not driven by the market capitalization standard. "Fundamental Indices" provide a partial solution. These are indexes whose constituent weights are based on economic principles rather than market capitalization.

Examples of available ETFs based on fundamental indexing include the PowerShares FTSE RAFI US 1500 Small-Mid (NASDAQ:PRFZ), PowerShares FTSE RAFI Dev Mkts ex-U.S. S/M (NYSEARCA:PDN), and PowerShares FTSE RAFI US 100 (NYSEARCA:PRF). Charges on these ETFs are generally slightly higher (typically 50bp) than conventional equity index trackers, but still significantly less than managed equity fund charges -- many of which, as explained earlier, are only closet trackers anyway.

Source: Do Trackers Offer Good Value?