All this week we are running a Guide to Active and Passive Investing to help you, the investor, make smart choices for your portfolio.
There was a time, years ago, when choosing an actively managed mutual fund seemed almost redundant. In fact, if you'd asked most investors back then why they chose an active fund over a passive fund, they might have wondered what you were talking about and remarked, "Aren't all funds actively managed?"
Today, of course, the choice is clearer. The growing popularity and prevalence of tracker funds and exchange-traded funds – driven, in part, by the fact that they tend to be cheaper to own than actively managed funds – makes using active funds seem more like a conscious decision than in years past.
But if you choose active management, it's important to make sure you're getting your money's worth. The following are key questions investors need to ask when using actively managed funds. If a fund you own, or are thinking of owning, doesn't pass muster after you've answered the following questions, consider looking elsewhere.
Question 1: How Much Is Active Management Costing You?
Cost of ownership is an issue regardless of a fund's investment style. And while it's true that passive funds generally have a built-in advantage in this area, as tracking an index tends to cost less than researching and picking individual securities, cost nonetheless matters just as much when picking actively managed funds.
How you can tell: Pay attention to the fund's ongoing charge, of course, but also to its Morningstar Analyst Rating for the Price, which indicates how the fund's fees compare with others of the sector. If the fund is rated Negative, look for a less-expensive option, preferably one with a Morningstar Analyst Rating of Neutral or Positive.
Question 2: Is Your Active Fund Truly Active?
Nothing frustrates an active-fund investor quite like discovering that his or her fund has been behaving like an index fund while charging four or five times as much. If you've chosen an actively managed fund rather than an index fund, chances are you're expecting the manager to earn his or her keep by making smart investing moves that differentiate the fund from the index.
Some funds, by design, don't stray too far from their benchmarks in terms of portfolio composition. And differing from the benchmark is not the same as beating the benchmark. But as an active-fund investor you'd be wise to get a sense of just how actively managed the fund is.
How you can tell: One way to assess the degree to which a fund's portfolio resembles its benchmark is by clicking on the Portfolio tab and comparing sector weightings with the benchmark’s. This won't tell you if the fund and benchmark have the exact same holdings, but it's a good way to see if the fund hews closely to the allocation and weightings used by the benchmark.
Reviewing the fund's performance versus the benchmark, found under the Performance tab, can also provide a clue as to how closely the two are in sync. Some fund managers display their “Active Share” – how different their fund is from the benchmark – on their websites. Neptune was one of the first companies to do this.
Question 3: Do You Understand the Fund's Strategy?
Choosing an actively managed fund is just the beginning of the process as active strategies can take many forms. Some actively managed funds take a growth- or value-oriented approach. Some use a broadly diversified portfolio with hundreds of holdings, while others focus in on just a few dozen names. On the fixed-income side, one actively managed fund may take on more credit risk, while a rival tends to play it safer and another fund may invest in one type of security – such as Gilts or corporate bonds – to a greater or lesser degree than the competition.
How you can tell: The best way to familiarise yourself with its strategy is by reading the fund's prospectus and the Fund Analyst Report on Morningstar.co.uk. Be sure you are comfortable with the fund's approach. If you're not – perhaps it takes too much risk for your taste, or not enough – consider switching to one that's a better fit.
Question 4: What Role Does the Fund Play in Your Portfolio?
An actively managed fund may provide exposure to a particular corner of the market – domestic large-cap stocks, foreign small caps, high-yield bonds, and so on – but it's a good idea to look beyond merely its category designation. After all, two funds in the same category can behave quite differently, depending on how they are managed. If the fund tends to deliver volatile performance, is there a counterweight elsewhere in your portfolio to smooth out your overall ride? Another question to ask: Does the fund hold a lot of cash? If so, its performance may lag in a fast-rising market, although having cash on hand could come in handy for stabilising returns – and scooping up bargains – during market downturns.
How you can tell: Check some key fund metrics to get a sense of how the fund operates. Under the Portfolio tab, check the number of holdings the fund has to see how diversified it is, as well as the fund's allocation to cash. Also review allocation breakdowns to see how the fund compares with other funds from the same category.
Is it fairly typical or an outlier? Finally, use Morningstar's X-Ray tools to look at the composition of your overall portfolio.
Question 5: Does Your Fund Manager Have A Proven Track Record?
Paying up for active management may not be worth it if the fund is run by an unproven manager. On the other hand, its fee may seem like a bargain if the fund is run by a seasoned pro that has been at the helm for a decade or more.
How you can tell: Click on the Management tab to learn more about the fund's manager – his or her tenure with the fund and past fund-management experience – as well as other funds he or she manages. If the manager's track record is long but he or she is a relative newbie to the fund, check out the performance of his or her previous funds to see earlier performance. How has the manager performed during times of particular volatility, such as the 2008 downturn or the 2013 upturn? In the Fund Analyst Report, pay particular attention to the People Pillar section to see what our analyst has to say about who's running the fund.
Question 6: Does Your Active Fund Have a Good Parent?
An active fund's parent company can be an important component of its success. Fund companies that receive positive Parent ratings from Morningstar's fund analyst team have pro-investor cultures that emphasise retaining employees, which is important when choosing active management.
The last thing you want is for a fund that you consider to be a core holding to change managers and approaches every few years. Good fund companies also are willing to close funds when they grow too large to execute their active strategies effectively. For example, some fund shops have closed their small-cap funds to new investors out of concern that continued asset growth will hamper their ability to effectively invest in smaller companies.
How you can tell: Make sure the fund's Parent Pillar has earned a Positive and, if you're a Premium Member, read how it got that grade in the analyst report. Also, pay attention to fund-company literature that describes its culture and how it treats its employees. You want a fund company that emphasises stability and putting investors first.
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