Six tips to find an active fund you can trust

In the wake of the Woodford fund collapse, here's how to ensure active holdings pull their weight.

In recent years, there has been an increasing focus on whether it is worth paying active fund fees. The alternative is simply to invest via index funds, which are cheaper, but come without the lure of potentially higher returns.

It is clear that the worst of all possible worlds is 'closet trackers' – funds that masquerade as active funds and charge similar fees but in fact simply mimic the performance of an index. The Irish Regulator recently became so concerned about this phenomenon that it took steps to investigate almost 200 funds, suggesting they may have been falsely advertised as actively managed funds while their performance stayed close to the index.

Look at active share

Closet trackers have not always been easy to spot. However, 'active share' has emerged as a useful tool to identify them. This measures the extent to which a portfolio differs from the benchmark index, and is given as a percentage.

An active share of 0% means a portfolio is identical to its benchmark and has no active positions. A value of 100% means the portfolio is completely active, holding none of the same shares as the benchmark index.

The theory is that a fund has to be meaningfully different from the index to have a chance of outperforming it.

Not all companies publish their active share. Unsurprisingly, it tends to be those with a high active share that do – companies such as Baillie Gifford, where active share will often be 80% or higher.

Active share, however, is not a proxy for good returns; instead its greatest use is in identifying those closet trackers, so investors can ensure they aren’t paying active fees for passive performance.

Rule of thumb: an active share score of less than 60% is a warning sign that a fund could be a closet tracker.

Buy the cheapest share class

When buying a fund, not only do investors have to pick the right fund – a feat of decision-making in itself – but they also have to pick the right share class, or risk paying excessive charges. This may sound like too much bother for an apparently tiny amount of money, but these charges can make a big difference to a savings pot in the long term. For example, an investment of £100,000 invested with an annual return of 5% would build up to £271,250 over 20 years. The same pot, with 1% drag from costs would build up to just £222,250 over the same period.

Fund groups don't make it easy to pick the right share class. There is no consistency in the naming conventions, for example. While all funds are either 'income' or 'accumulation', they could also be tagged A, Z or R, or another letter, with no pattern as to which denotes the cheapest share class.

There used to be greater jeopardy. Previously, the normal share classes for retail investors bundled up into one charge all of an investor's costs: the cost of the platform, the cost of the investment manager and the cost of the advice.

This meant that investors might be charged 5.5% upfront and 1.5% ongoing fees.

The regulator has forced companies to unbundle these charges, creating so-called 'clean' share classes. Today, the difference between share classes is less stark: some fund platforms have negotiated special reduced fees on certain funds, which creates 'super clean' funds. There may also be 'professional' share classes, limited to certain types of investor.

Rule of thumb: Simply buy the cheapest share class offered by your broker.

Be wary of key-man risk

When it comes to active funds it is important to be alert to the problems of key-man risk. Investment processes are important, but a good fund manager can bring an element of magic that is not necessarily replicable by someone else.

Equally, environment is important – a fund manager who moves may not necessarily be able to generate the same success elsewhere. They may not have the same analyst network or the same skilled trading team, which can affect their ability to generate returns.

Key-man risk doesn't just come from the departure of the manager; it can create disruption in other ways. For example, investors may choose to follow the 'star', which could lead to rising redemptions.

Rule of thumb: look closely at the rest of the management team to see whether a succession plan is in place.

Pick managers with a robust investment process

No one likes to feel that the person taking care of their long-term savings is just winging it. If they are successful, it is good to know it isn't simply a fluke. Some fund managers can look very successful simply because they happen to have backed one or two good stocks. As such, it is worth backing those managers with a well-established, coherent and repeatable investment process.

'Investment process' is really just a grand way of saying that a fund manager can adequately articulate what they are doing and why. That means being clear about what the fund is trying to achieve – whether it is income, long-term capital growth or absolute returns – and the type of environment in which the fund will do well, and when it will do badly. The fund manager should be able to explain why they hold the stocks they do, and how they are chosen.

Some groups, such as Aberdeen, will do this at a firm-wide level; in other cases, it will be down to the individual investment managers. An investment process that seems too complex is often best avoided. Too often, it's because the fund manager can't articulate what they do.

Rule of thumb: look for a fund manager with a straightforward approach that you can understand.

Know what you're paying for (total product cost)

There has been a lot of focus on fund management fees in recent years. An increasingly vocal passive industry has questioned whether the fees investors pay for active funds are worth it, when a relatively small number of active managers consistently perform better than the index. Active managers counter that when they do outperform, it's more than worth any extra fees.

In assessing those fees, investors should be aware that the annual management fee is not the end of it – either for active or passive funds. There will also be dealing charges, legal fees, auditor fees, and other operational expenses. These are reflected in the ongoing charges figure (OCF). This may be 0.1-0.2% higher than the stated annual management fee. New rules from Europe in the form of MiFID II require investment managers to state all the transaction costs that are charged to their funds, on top of the OCF.

It is unfashionable to say it, but the extreme granularity around fund fees demanded by the regulators may not be particularly helpful. No investor should buy an expensive, poorly-performing fund, but neither are the cheapest funds necessarily the best option.

Rule of thumb: ultimately, buying a good fund will do more for long-term returns than merely finding the cheapest option.

Avoid illiquid assets in an open-ended fund

Until recently, this would have been seen as a minor point, unlikely to affect the majority of portfolios. However, the importance of liquidity has been thrown into sharp relief by the Woodford Investment Management scandal, where former star fund manager Neil Woodford was forced to suspend his open-ended Woodford UK Equity Income after he struggled to sell a number of illiquid holdings to meet redemptions.

At the heart of the problem is a mismatch between what is being promised to the investor and what is achievable for the fund manager. To meet any redemptions in an open-ended fund, the fund manager must sell assets. Most fund managers offer daily liquidity, so investors can get their money out every day.

Tricky small fry 

The problem is that not all of the underlying assets can be sold in a day. Big shares are generally fine, but it gets a little trickier among smaller companies and alternative assets such as property. A commercial property fund may only hold 10-15 buildings; selling them at short notice isn't usually an option. Moreover, corporate bonds are bought and sold over the counter, rather than 'on exchange', and there can be periods where liquidity dries up.

It doesn't help that liquidity is a moving feast. At times of market distress the exit door can become very narrow. The seller may be trying to offload an asset that no-one wants to buy. This can be a particular problem in emerging markets, where there may be a lack of liquidity both in the currency and in the shares themselves.

Another problem is that managers may be forced to sell their most liquid holdings to meet redemptions. By definition, it is those assets that the greatest number of people want to buy. In other words, fund managers may be forced to sell the crown jewels of their portfolios to meet redemptions. This can compound weak performance.

Most managers of less liquid assets in open-ended funds will have strategies in place to help them deal with the potential risks. They will often have a proportion of their fund in cash to meet any immediate need for redemptions. However, this has its problems because it means that part of the fund is uninvested and, as such, can act as a drag on performance.

Many property funds also retain some holdings in property shares. These give access to commercial property returns, but are readily sold should the manager need to meet redemptions. Equally, managers of, say, emerging market or smaller companies funds may keep some of their holdings in larger, more liquid companies for the same reason.

However, no manager holding illiquid assets can deal with catastrophic redemptions. Eventually, they reach a point when they run out of rope. This happened to property funds in the wake of the Brexit vote and during the global financial crisis, and to Neil Woodford when the performance of his multi-billion pound fund tanked. In these circumstances, a fund may be forced to stop redemptions for a time. Investors won’t be able to get their money out during that period.

If this presents a rather apocalyptic picture, it doesn't happen very often. Commercial property is a specific case; few fund managers are as high-profile as Neil Woodford and attract either the same level of assets or the same level of redemptions.

It is possible to avoid the problem altogether with investment trusts. Investment trusts are 'closed-ended' and therefore the manager doesn't have to sell assets to meet redemptions. It can't stop the discount widening, but it does mean the underlying assets aren't compromised. In this way, it is often better to invest in less liquid assets through an investment trust rather than an open-ended fund.

Rule of thumb: investment trust structure is much better suited to illiquid investments.