How to choose an active fund

When selecting an active fund for your portfolio there is a lot to think about. How do you narrow down the field of the several thousand investments available?

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  1. Rob Morgan

In contrast to passive investments or ‘trackers’, which simply aim to replicate the returns of an index, say, the FTSE 100, ‘active’ funds employ fund managers to try to beat it by selecting better-performing investments.

Many active fund managers don’t beat the market over the long term, so lots of investors choose the passive route for low cost and simplicity. Often these funds own all or most of the constituents of an index in order to match its return. However, active funds can be well worth considering, especially in areas that are less well covered by the investment community.

In smaller companies, for instance, fewer professionals are assessing and analysing businesses. Proprietary research can more often uncover opportunities or risks that are not widely acknowledged. Active fund managers can potentially harness these anomalies for the benefit of their investors.

When selecting an active fund for your portfolio there is a lot to think about. The asset class and geographical area are likely to be important if you are looking to gain exposure to a certain area. Past performance too tends to influence investors – but this isn’t a guide to the future. Beyond this how do you narrow down the field of the several thousand investments available?

Here is a selection of characteristics we think are worth considering when selecting an active fund. They reflect some of the principles we use when we select funds for our Foundation Fundlist – you can read more about the selection process here.

Clear and consistent strategy

Understanding the process behind a fund is vital when assessing if, and in what circumstances, it might outperform in the future. For instance, the approach of some managers is more likely to mean outperformance in rising markets. Others tend to protect capital better during less favourable market conditions because they take a more conservative approach. 

Whatever the approach, the outperformance and underperformance of active funds tends to be lumpy and taking this into account can help put returns into perspective. ‘Style drift’, a departure from an established approach or philosophy, should be viewed sceptically as it may mean it’s harder to predict whether a fund will do relatively well or poorly going forward.

Being different

You can only beat the market if you invest differently to the market. If a fund’s portfolio is similar to the market’s constituents, then it can likely only offer average performance – and probably below average given the generally higher fees of active management.

If you are paying for active management then that is what you should get. By comparing how many holdings an active fund has in common to its benchmark it is possible to establish how ‘different’ it is, and therefore the extent to which it may deviate from it in terms of performance. This is what is known as ‘active share’.

Different doesn’t automatically equal better, though, and outperformance relies on the skill of the fund manager. What you can expect from a fund with high active share is that performance could deviate significantly from its benchmark – for better or for worse.

This is why even the best active funds inevitably have poor periods and it’s important not to run out of patience too soon. Shorter term underperformance can be a result of a certain style being out of fashion rather than a lack of ability, so it’s important to try and understand the reasons behind a fund’s performance when making the decision to buy or sell. There’s more about active share here.

High conviction

By holding too many companies in a fund, a manager can ‘dilute’ their best ideas. In general, we think its best if managers have the courage of their convictions and limit the number of stocks in their portfolio so that each one can contribute meaningfully to returns.

There’s no prescriptive answer to what we consider sensible, but for equities, a 40 to 60 holding portfolio is often an appropriate size to balance the need to diversify risk while ensuring the fund is punchy enough to be able to generate significant outperformance. There’s an argument for holding more as the companies in question get smaller, as well as in more cautious areas such as bond funds where numbers of holdings tend to run into the hundreds. This is due to the greater need to mitigate risk and the usually finite life of each of the underlying assets.

Appropriate fund size

In general, it’s easier to beat the market with a small amount of money than with a lot. While investors are undoubtedly attracted to ‘star’ managers and their ‘blockbuster’ funds, there is a lot to be said for funds that stay small and nimble. They are more likely to be able to trade in and out of their holdings without having an impact on the price because they own a smaller quantity of stock. They are also less likely to run into difficulties of ‘illiquidity’ – not be able to buy or sell a holding in the quantity required.

Investors should be wary of fund management companies that put ‘asset gathering’ before performance – marketing funds as much as possible with little regard to how the strategy can absorb the additional money. Allowing the fund’s size to become too large can compromise the investment process, especially in areas that are less ‘liquid’ such as smaller companies.

It’s sensible to prioritise managers seeking to grow assets sustainably and with a stable, diverse range of investors, with a view to closing the fund to new investment if necessary. Certain funds can become victims of their own success, rapidly drawing in new investment as a result of strong performance. In these situations, investors should be sceptical that market-beating returns can be sustained in the longer term and should think about what might unfold if flows into the fund reverse.

This factor isn’t such a problem for investment trusts. They have a fixed pool of capital to invest rather than one that expands or contracts according to investor demand as with unit trust or OEIC funds. However, they can still grow through new share issuance. There’s more on the differences between them here.

Fair charges

Fund costs and transparency are increasingly in the spotlight, and rightly so. Fund charges can be a significant impediment to investors’ returns so it’s important to consider the charging structure of a fund, as well as its ‘add on’ costs.

Fund managers are now required to state the transaction costs that are charged to their funds – the amount it costs them to buy and sell the underlying investments, on top of the ongoing charges figure (OCF), which covers fund operating costs, including the fund manager's fees for running the portfolio (the annual management charge or AMC, but not any performance fees), along with other costs, such as administration, marketing and regulation.

On Charles Stanley Direct two figures for a fund are displayed on its respective webpage, the annual management charge and ‘Total Ongoing Cost’ (TOC), which combines the OCF, the transaction charges figure and any incidental extra costs such as performance fees. Please note the TOC is calculated using historic data and charges could be higher or lower going forward, especially if transaction charges and/or any performance fees taken is significantly different.

Past performance is not a reliable guide to future returns. This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus. If you are unsure of the suitability of your investment please seek professional advice.

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