How to choose the best active funds for your Isa

published 25 February 2017

170224-stocks-b — Sometimes, it's worth paying for actively managed funds

Yesterday I told you all about the merits of passive investing.

Passive funds funds that track the market are predictable and cheap. Active funds where a fund manager tries to beat the market usually fail in their task, and they are expensive.

So why would you ever buy an active fund?

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What if I told you that there's a type of active fund that shifts the odds in your favour? That actually manages to beat the market on a regular basis?And better yet, is sometimes available at knock-down prices?

Sounds too good to be true. And yet such a fund exists.

It's called an investment trust...

What is an investment trust and why are they better than open-ended funds?

However, unlike open-ended funds (Oeics or unit trusts), an investment trust is a listed company. You buy shares in the trust on the stock exchange, rather than investing via a fund supermarket or directly.

We'll discuss the structure a bit more in a moment. But the point is, investment trusts perform better than open-ended funds. A recent study by JPMorgan Cazenove found that, looking across ten market fund sectors (things like UK smaller companies, emerging markets, or Japanese stocks), investment trusts beat open-ended funds across the board over five years, and in all but two sectors over ten years.Meanwhile, over five years, more than 50% of trusts beat their benchmark in all but one sector.

In other words, your odds of beating the market would have been pretty decent across most sectors in the last decade, even if you'd just chosen an investment trust at random. And they'd certainly have been a lot better than if you'd picked an open-ended fund.

Why do investment trusts outperform their open-ended rivals? It's partly because of thestructure. When you buy shares in an investment trust, you buy them from another investor. No money flows in or out of the fund, so the manager doesn't need to worry about selling off assets in a panic.

In an open-ended fund, any money invested or removed comes directly from or goes into the underlying portfolio. That means the manager needs to pay attention to the ease ofbuying or selling the underlying assets.

The bestillustration of this in action is to look at what happened to commercial property funds in the wake ofthe Brexit panic. If you own an office block, you can't just sell it overnight. It takes time. And the more desperate you are to sell, the less money you'll get for it.

So when people threatened to pull cash out of commercial property funds en masse after Britain voted to leave the European Union, the funds had to stop them. They simply couldn't raise the money to fund theredemptions' quickly enough, without hurting existing investors.

You can probably already see the benefits here. If you don't have to worry about flogging off assets in a hurry, you can own more obscure and potentially profitable assets for the long run. It opens up the ability to buy smallstocks, or property, or exotic markets.

It also means that managers can maintain a cooler head during market panics. They don't have to worry as much about clients yanking their money out of the fund. Certainly, clients might sell out, and the share price might fall but there's no direct effect on the manager in terms of handling the underlying portfolio.

That helps a manager act with more conviction, which is generally a good thing investing more money in their best ideas, rather than spreading themselves toothin, tends to pay off as long as your manager is reasonably competent.

Investment trusts can also borrow money ("gearing"). This amplifies returns when stocks go up and amplifies losses when they go down, but performance history suggeststhat managers tend to be both conservative with leverage and pretty good at timing when they should borrow money and when they should cut back.

How to bag a bargain

You see, the fact that investment trusts trade on the stockmarket means that the share price of the investment trust itself is separate to the value of the underlying portfolio (the net asset value, or NAV).

Often, the share price trades below the NAV ie, at a discount. If a trust trades on a discount of 10% for example, it means you are able to buy one pound's worth of assets for 90p. So even if the underlying NAV goes nowhere, but the discount"narrows" (ie gets smaller), you'd end up making money.

Of course, the discount can widen. Or sometimes a popular trust might end up trading on a"premium" ie above the NAV. But the existence of discounts certainly provides another way to profit from investment trusts or spotinterestingopportunities. And it also provides a very visible "sense check" forpotential investors.

Investment trusts have plenty of other attractive features, which we recently covered in our MoneyWeek special on investment trusts.

But if you just want to know which ones to put into your Isa, then you're in luck.Conveniently enough, we've put together a model portfolio of our favourite investment trusts here at MoneyWeek. The portfolio has performed well since it was launched in 2012 keeping up with global markets, and beating the FTSE All-Share over that period. There are only six trusts in the portfolio, and they are all well-known and easy to trade, so it's very simple to set up.

MoneyWeek subscribers can seethe latest update to our model investment trust portfolio here. If you're not already a subscriber, sign up now.

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.