ISA tips: How to work out whether a fund is truly active
We outline how to work out whether a fund is truly active or a 'closet tracker'.
25th March 2019 10:38
by Kyle Caldwell from interactive investor
We outline how to work out whether a fund is truly active or a 'closet tracker'.
The next few weeks or so are typically the busiest time of the year for stockbrokers, as investors try to maximise their ISA contributions ahead of the tax year end. For those looking for ideas on funds to invest in, the first decision to make is to whether to choose an active or a passive fund.
Those opting for the latter have less homework to do: decide on the stock market and index you want to track, and find the cheapest index fund or exchange traded fund you can. Check the fund's tracking error, which shows how efficient the passive fund is at replicating the performance of the index it follows. The lower the tracking error, the better.
More time and effort is required when choosing an actively managed fund, because far too many allegedly active funds are actually index-huggers or 'closet trackers' with portfolios that fail to deviate significantly from the index, but cost considerably more than an index tracker.
One reason why these substandard funds continue to exist is that fund managers fear losing their jobs if more radical bets turn sour. In addition, investor inertia allows closet trackers to continue producing mediocre performance while charging active management fees.
Beyond that, take a look at any prospective fund's top 10 holdings and compare them with the top 10 constituents in its benchmark index. A large overlap should set off warning bells. 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.
A less crude approach is to 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.
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.
This article was originally published in our sister magazine Money Observer, which ceased publication in August 2020.
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.
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.