Interactive Investor

ISA tips: five easy ways to find an active fund worth its salt

25th February 2022 10:55

Kyle Caldwell from interactive investor

Buying active funds can help you outperform the market, but there are some things you should know first. Here’s our checklist for investors when sizing up an active fund to avoid buying a dud.

The next couple of weeks are typically the busiest time of the year for platforms, including interactive investor, as investors try to maximise their ISA contributions in the best way ahead of the tax year end.

For those looking for ideas on funds to invest in, investors need to weigh up the merits and drawbacks of both active funds and passive funds. The latter go by the names of index funds, tracker funds or are structured as exchange-traded funds (ETF).

An active fund manager invests in 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 an income to investors, as well as hoping to deliver a market-beating return. However, there is no guarantee the fund manager will beat the market.

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. A 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. By definition, they will not outperform – so on the one hand investors are giving up the chance to make more money than the market. However, going down the passive route also means investors will not notably underperform.

For many investors having a mixture of active and passive funds is a sensible approach, with the active funds aiming to add spice to the overall returns. However, more time and effort is 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, however, are designed to fail as they are index-huggers or 'closet trackers'. Such funds do not deviate significantly from the index. As a result, investors tend to underperform the index due to a combination of the fund not being active enough and the yearly fee eating into the return.

A key reason why these funds continue to exist is because some fund managers fear losing their jobs if they notably underperform the index. As a result, they play it safe. This is to the detriment of their investors who are still paying the going rate for an active fund – which is typically 0.85% to 1% a year (£85 to £100 on a £10,000 investment). Passive funds tend to have fees of 0.25% or less.

Below is a checklist of things for investors to look for when sizing up an active fund to avoid buying a dud.  

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 does on the tin will also help you potentially spot if a fund manager changes the way they invest. If a fund 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 at the outset.

Look at top 10 holdings and performance

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

Then examine how the fund has performed against its benchmark index. If the two 'lines' look similar over both the short and the long term, the fund manager is evidently not taking many active bets.

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

Active share ratio

Look at the fund's 'active share' ratio, where available, which shows how much its holdings differ from its benchmark's. The higher the ratio, the more active the fund manager is likely to be.

A fund that holds the same stocks as its 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 warning sign that a fund could be a closet tracker.

Not all fund firms publish their active share. Unsurprisingly, it tends to be those with a high active share that do.

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 their complexity, investors should consider using the various bells and whistles to their advantage.

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

Take a look at our rated funds

And finally, as part of your research, do make use of interactive investor’s Super 60 and ACE 40. The latter is our ethical rated fund 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.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.