ISA tips: 10 ways to find a fund worth its salt

The clock is ticking down to tax year end, with investors having just over a week to make the most of their yearly ISA allowance. The £20,000 allowance will re-set in the new tax year, which starts on 6 April.

Below is a checklist for investors to use when sizing up an active fund, which are those managed by a professional investor.

However, first investors need to weigh up the merits and drawbacks of both active and passive funds.

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Active versus passive

An active fund manager picks a selection of assets (such as shares and bonds), and their job is to outperform rivals and a comparable performance benchmark – such as the FTSE All-Share index for UK funds that buy shares. Some funds aim to provide investors with an income, as well as deliver a market-beating return. However, there is no guarantee the fund manager will consistently beat the market, and more tend to fail than succeed.

Passive funds are called index funds, tracker funds or are structured as exchange-traded funds (ETFs). The core difference is that unlike index funds, ETFs can be traded throughout the day on the stock market, much like individual shares. For long-term investors, the difference is not important.

Rather than trying to pick the best individual shares, passive funds aim to replicate the performance of an entire index. After subtracting fees, investors will receive a slightly lower return than the index the fund is tracking.

Passive funds offer investors cheap, simple and effective exposure to global stock markets. A passive fund tracking the US or UK market, can be bought for a charge of less than 0.1% a year, which is £10 on a £10,000 investment.   

Another key attraction of passive funds is their simplicity; investors know from the outset that they will broadly get the return of the stock market index they have chosen. They will not outperform, so investors are giving up the chance to make more money than the market. However, going down the passive route means investors will not experience notable underperformance.

For many investors, having a mix of active and passive funds is a sensible approach. Under a core/satellite strategy, low-cost passive funds could make a sensible core (comprising 70% of a portfolio), with the active funds aiming to add spice to the overall returns as satellite holdings.

However, more time and effort are required when choosing an actively managed fund to avoid those that persistently fail to add value.

Some active funds underperform due to the fund manager making the wrong calls. Others are index-huggers or potentially “closet trackers”. Such funds do not deviate significantly from the index. Regardless of whether an active fund manager outperforms, investors still pay the going rate for an active fund, which is typically 0.85% to 1% a year (£85 to £100 on a £10,000 investment).

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Know what you’re buying

Understand how a fund invests and what it is aiming to achieve. Doing so will help you decide whether to act if fund performance is not up to scratch.

The fund manager should be able to explain why they hold the stocks they do, and how they are chosen. Such information should be available on the fund factsheet or on the fund management firm’s website. If the fund manager does not articulate this clearly, it is probably best to steer clear. After all you wouldn’t buy a car without the instruction manual.

In addition, knowing what the fund says it will do also helps you to potentially spot if a fund manager changes the way they invest. If a manager is a “value” investor and then starts to buy “growth” shares, it might be time to act, as it is no longer the same fund you bought.

Moreover, a fund manager changing his or her approach can indicate a lack of confidence in the way they invest. Simon Evan-Cook, a fund-of-funds manager at Downing Fund Managers, says when this happens “it is the biggest red flag in the professional fund-buying world”.

He adds: “If you bought [a fund] on the basis the [fund manager] was going to be buying value-based stocks and if they’re suddenly doing something which they’re not used to doing, that they don’t have any expertise in, then why on earth would you hold that fund?”

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Look at the top 10 holdings and performance

When sizing up a fund, look at their top 10 holdings and compare them with the top 10 constituents in the fund’s benchmark index. A large overlap should set off warning bells that the fund may not be active enough.

Examine how the fund has performed against its benchmark index. If the two “lines” look similar over both the short and long term, the manager is probably not taking many active bets.

If the fund has underperformed significantly over a certain period, don’t write it off straight away as there may be a good reason, such as its investment style being out of favour.

Compare apples with apples

When comparing fund performance, it is important to compare apples with apples. For many sectors, the fund sector average return is not a useful yardstick to measure performance due to the variety of strategies and approaches.

So, if a fund adopts a “growth” approach, it is better to compare it against other growth funds or a growth index.

Algy Smith-Maxwell, who manages fund-of-fund portfolios for Jupiter, says: “I like to compare apples with apples. I don’t look at the sector average. I look at how the fund has performed relative to its style.”

Care also needs to be taken when assessing performance over the three standard time periods of one, three and five years.

Smith-Maxwell says that he prefers to judge performance over periods involving a significant stock market event.

He says: “I don’t like the discrete one-, three- and five-year performance numbers. It is far too short term. When I am looking at the performance of funds, I look at the performance between different inflection points. I will want to see how a fund performed during the financial crisis, how a fund performed during the pandemic, and how a fund performed over Brexit. [I want] to see how the fund performed in bad periods, and how the fund fared in periods when markets got really excited.”

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Active share ratio

To help find a fund that is investing sufficiently differently from the wider market, look at the fund’s “active share” ratio, where available. This shows how much its holdings differ from the benchmark. The higher the ratio, the more active the fund manager is likely to be.

A fund that holds the same stocks as the benchmark in the same proportions will have an active share of 0%, while a fund that holds none of the index’s stocks will have an active share of 100%. An active share score of less than 60% is a potential warning sign that a fund is not active enough.

Take advantage of the investment trust structure

Investment trusts, which are another type of fund, have certain structural quirks. But rather than being put off on the grounds of complexity, investors should consider using the various bells and whistles to their advantage.

Our beginner's guide to investment trusts explains everything that investors need to know.

Size matters

When it comes to active funds, in some cases size matters.

This is because when a fund gathers a large amount of investor money, the investment universe (the stocks the manager can chose from) shrinks. This is because the manager must take into greater account the size of a company. If the company is too small, depending on the size of the fund, they may not be able to buy it because they’ll need to own a larger stake in that smaller company due to the size of the fund.

For some funds, such as those investing in large global companies, fund size is less of an issue. But for other funds, such as those investing in UK smaller companies, the fund size can be problematic as it restricts the manager’s choice.

Downing’s Evan-Cook says: “If a fund manager finds an amazing little company, but is running a £20 billion fund, realistically they can only put in 0.2% of the fund. So even if that stock then doubles, if you own 0.2%, then you’re getting 0.2% uplift.

“But if you can put 5% of the fund into that [company], you’re getting a 5% return on that stock doubling, which is clearly going to make a very, very big difference to the performance of that fund.”

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How is a sustainable fund engaging with companies?

If you prefer to choose a fund that invests in businesses “doing good” in some form or other, you have plenty of choice. To find funds that invests sustainably check out our sustainable investing long list.

While there’s different approaches, most sustainable funds engage with companies by challenging them on issues that matter to investors.

Some funds provide examples of how they have engaged with companies in fund literature. Others don’t, or instead opt to keep the work they do to themselves. In my view, it is far better for DIY investors to be given examples.

Big fund firm or boutique?

The biggest fund firms – the top 20 by size – typically have dozens of funds across various asset classes and sectors.

The smaller firms, known as boutiques, usually stick to one area such as emerging markets or smaller companies, for example.

With a big firm, there’s greater resource and arguably more oversight. However, backing a boutique has the advantage of the fund manager’s interests being more directly aligned with fund performance. This is because he or she typically has a bigger stake in the overall business.

Look at our rated funds

Finally, as part of your research, do make use of interactive investor’s Super 60 and ACE 40 investment ideas. The latter is our sustainable rated funds list. Both contain active and passive fund options. The lists aim to provide a set of high-quality choices across different asset classes, regions, and investment types.