Interactive Investor

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

9th March 2023 15:31

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 clock is ticking to tax year end, with investors now having only a couple of weeks 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.

For those looking for fund ideas to invest in, investors need to weigh up the merits and drawbacks of both active and passive funds.

Active versus passive

An active fund manager, a professional investor, 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 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, and more tend to fail than succeed.

Passive funds go by the names of 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. By definition, they will not outperform, so investors are giving up the chance to make more money than the market. However, going down the passive route also 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, 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, however, 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 job 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).

Below is a checklist for investors to remember 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 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 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 long term, the fund manager is evidently 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.

Active share ratio

Look at the fund's 'active share' ratio, where available, which 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 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 is not being active enough.

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.

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. There are now more 200 funds that invests sustainably, which interactive investor highlights in our sustainable investing long list.

While there’s lots of 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.

An example of good practice in this respect is BMO. The firm produces an annual report on how many companies they have engaged with over the past year and the ‘milestones’ achieved. 

Three of BMO’s Sustainable Universal MAP funds are endorsed by interactive investor as part of our Quick-start fund choices for beginner investors.

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 – 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 has a bigger stake in the overall business.

Look at our rated funds

And 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 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.

Please remember, investment value can go up or down and you could get back less than you invest. If you’re in any doubt about the suitability of a stocks & shares ISA, you should seek independent financial advice. The tax treatment of this product depends on your individual circumstances and may change in future. If you are uncertain about the tax treatment of the product you should contact HMRC or seek independent tax advice.