Imagine you own a global exchange traded fund. You think you are passively exposed to the global stock market, but the truth is you are only exposed to a small fraction — big companies that have done well and are now expensive. You are effectively long momentum and short value.

That might be what you want. If it isn’t, you will need to shift some money into active funds, with real people making real stock picking decisions about potential future winners.

That might feel brave, given the reams of research showing active funds as a whole regularly underperform any index you choose to use. But the good news is there’s no shortage of research into what makes an active fund successful. Furthermore, there is plenty to suggest that while the average active fund regularly underperforms the market, there is no need for the average active fund investor to do the same.

Interactive Investor provides a Private Investor Performance Index every year. Over the three years through 2022, the average Interactive Investor portfolio both beat the UK market as a whole and the Investment Association mixed asset sector average, with the wealthiest customers doing the best of all (making double that of the average investor). Even though there is lots to quibble with here — Is the IA mixed the right benchmark? Are II investors more stock pickers than fund investors? — it suggests underperformance is not a given for active investing.

If you’re looking for an active fund, the first thing to be sure of is whether it is genuinely active — not just an expensive tracker. Even now, closet trackers — funds that charge you active fees but effectively track the index — abound: According to research from Peer Analytics, around 30% of US equity mutual funds are still so passive they “fail to merit a typical fee.” 

The simple way to do this is to look at the fund’s active share. This basically measures how different to the index any given portfolio is. Replicate it exactly, and your active share is zero. Have nothing in common with it, and it’s 100. If your fund has an Active Share (AS) of under 60 (that is, 60% of the fund’s holdings mirror the index), it is not an active fund but a tracker or a closet tracker. Don’t buy these.

You can usually get hold of a fund’s AS number pretty easily on the fact sheet. If you cannot, just look at the top 10 shareholdings. Heard of them all? Maybe move on.

This matters: There is evidence to suggest that high AS funds not only outperform low AS funds but also outperform tracker funds both before and after expenses. Outperformance comes from stock picking.

AS is not a perfect measure of the merits of a fund (as managers running funds with low active shares will tell you at every opportunity). A fund with only five stocks would have a high AS but also an insane level of risk, for example. And you could, of course, give yourself a 100% AS by benchmarking yourself to one index and passively tracking another! Still, AS is a good and simple place to start.

Next to consider is fees. You have to pay for active management, but every pound of cost is a pound of performance lost. Invest £100,000 ($120,620) for 10 years with a charge of 1% a year, and it will cost you £16,196 (assuming a 6% return a year). Make that 0.5% and the cost falls to £8,271. The lower the fees, the better.

Fund managers like to tell you this isn’t so: After all, if you outperform the market by 5% a year forever, who cares if you charge a little more for the job than the underperformers? That’s a compelling argument. But it misses the point that fees are a certainty and performance a possibility. We must work with what we can control.

In good news, the level of active fees has come down a lot in recent years. The trend, says investment bank Numis, is “resolutely continued reductions in management fees.” That matters too: Recent research shows that before fees, the average active fund often does outperform the average passive. So the lower the fees, the higher the chance of outperforming. 

The same goes for turnover — every trade costs. You are looking for a fund offering clear, not constantly changing, conviction. The lower the turnover numbers, the better.

Then there is size. Most studies show that smaller funds and newer funds outperform bigger and older ones. That makes sense. New funds need to prove performance before they can raise much money, so they can’t allow themselves to be distracted by asset gathering. Smaller funds also have the opportunity to be more nimble and worry less about liquidity than bigger funds (which can’t buy enough of smaller companies to not run into trouble when they try to sell).

A Morningstar study suggested there has been some change to this dynamic recently — with bigger funds outperforming smaller. But this may have something to do with the huge outperformance of the mega caps in the US (these being more held by big funds than small). With that dynamic over, and the opportunities increasingly in small- and medium-sized stocks (the types of stocks the very big funds can’t buy), the outperformance of larger funds might be less prevalent. We will see.

Finally, there is skin in the game. For many fund managers, marketing a fund is more lucrative than focusing on making money with a fund — let’s not forget that the more money that pours into a fund, the more money you make from your ad valorem fee, regardless of performance.

With that in mind, you want your manager to be making money from making money — not from gathering assets. Knowing he has a large amount of his own money backing his convictions is a good start — and there is plenty of long-term evidence to back up the instinctive idea that the more money a manager has in his fund, the better he might manage it.

Consider a Swiss Finance Institute paper that looked at how managers apply ESG metrics across funds. Turns out the more skin in the game they had, the less attention they paid to ESG matters. This tells you two things: First, that money managers believe in ESG as a performance enhancer less than they may say they do; second, the more they are co-investors in a fund, the more prepared they are to focus purely on returns. Both are useful bits of information!

How much skin in the game their managers have is not the kind of thing most fund management companies advertise. So ask.

Checking all these different elements before investing might sound admin-heavy. But look at it like this. According to BMO, the best-performing active fund in the UK outperformed the average passive fund by a multiple of 7.2 times in the 20 years to 2020. Some admin is worth doing.

P.S. If you know any funds that fulfill all the criteria above, please let me know.

This article was provided by Bloomberg News.