If you decide to use a fund to invest in the stock market, you have two main options.
You can buy an actively managed fund it will cost you more, but in return, the manager will try to beat the market or you can buy a passive' fund, which just aims to track the underlying index. It won't give you anything more than the return on the market, but it's a lot cheaper because there are no stock-picking decisions to be made.
We've always been big fans of passive funds. That's primarily because history tells us that most active managers fail consistently to beat the market partly because their fees are so high. Why give them all that money if they can't do the job?
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That said, trackers aren't perfect, which means we're also hopeful that the banning of commission payments to financial advisers will start to bring down the cost of active management.
If fees fall far enough, then funds that offer clear, focused strategies with managers willing to take a patient, contrarian view (such as Terry Smith's Fundsmith equity fund) might well become more attractive alternatives to passive funds.
But there's one type of fund you should never have in your portfolio the closet tracker' fund. This gives you the worst of both worlds you pay the high fees of active management, but what you actually get is, in effect, an index-tracking fund.
A recent study by wealth manager SCM Private suggests there are a lot of these funds out there. Of 127 UK equity funds, with £120bn invested between them, nearly half were deemed to be closet-tracking' the FTSE All-Share index.
Under SCM's measure, a fund is a closet tracker if 60% or fewer of its holdings (its active share') differ from the underlying index. A pure tracker fund would have an active share of zero.
Closet tracking is one of the biggest rip-offs in the fund management industry. A typical active fund that invests in the British stock market will have a clean (without commission) annual management charge of 0.75% and a total expense ratio (TER) of around 1%.
By comparison, the Vanguard UK Equity index tracker fund has a TER of just 0.15%. So if your manager is a closet index tracker, then you are paying well over the odds for the fund.
Why is closet tracking so widespread?
The easiest way to do that is to build a portfolio that is very similar to the underlying index. You might not deliver epic returns, but you will always avoid underperforming the index so badly that you stand out as a fund to sell.
You see, if you really want to beat the index, you need to invest very differently in it. Sure, if you get it right you'll be a hero while the outperformance lasts. But get it wrong and even the best managers do then the chances are you'll lose clients, and maybe even your job. It's this 'career risk' that persuades managers to become closet trackers.
Is your fund a closet tracker?
Take the example of a UK equity fund, benchmarked against the FTSE All-Share index. Go to the FTSE website, which will show you how the index is made up.
Five stocks make up over 25% of its value. Now get the latest factsheet for your fund (available on the company website) and look at the top ten holdings.
If the top five read something like Royal Dutch Shell, HSBC, Vodafone, BP and GlaxoSmithKline (the five biggest stocks in the index), it's a warning sign that you may have a closet tracker on your hands.
Next, work out the tracking error of the fund. This just measures how differently the fund has performed compared to the index. You can do this by simply subtracting the return on the index from the return on the fund. Go back at least five years.
If you end up with a small number the closer to zero, the more suspect it shows that the fund has performed very similarly to the index, suggesting it might be a closet tracker.
Also look at websites such as Morningstaror FE Trustnet, which do a lot of analysis on individual funds. One figure to look for is the fund's R-squared (R). This measures how much the fund's returns move in line with (or correlate to) the returns of the index. A fund with an R of more than 0.8 may be a closet tracker.
If you do hold a closet tracker, sell and buy a cheaper passive fund (we look at how to choose one below). If you really want to pay for active management, watch out for high fees and ensure that you understand the manager's strategy, and that it involves doing something more complicated than just hugging the benchmark.
Is your tracker any good at tracking?
exchange-traded funds (ETFs)
An index fund should usually slightly underperform its index, due to expenses. However, some of the index funds out there are very bad at matching their target index, and do much worse.
If a fund lags the performance of an index by much more than its annual expense ratio, then you should probably give it a miss.
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