Isa tips: how to work out whether a fund is truly active

DIY Investor Toolkit: we outline how to work out whether a fund is truly active or a ‘closet tracker’.

The next six 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 stockmarket 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.

To avoid substandard funds and find truly active ones, the first port of call is Money Observer’s Rated Funds listing of funds we believe to be superior actively managed options.

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.

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