Why would I invest in an active fund when trackers are cheaper?

Ask the experts. Paul Angell is on hand to answer your questions about investments. If you'd like a question considered for a future edition, send it in now.
Or alternatively leave a rating for the article and include your question in the comment box.
It’s hard for me to understand the case for active funds for stock investing. If tracker funds are almost always cheaper, when would you choose an active fund instead?
David M

Paul Angell, AJ Bell Head of Investment Research, says:

You’re correct in saying that tracker funds, which follow an index, are typically cheaper than active funds, where investments are chosen by a fund manager. Further, research carried out by AJ Bell shows that tracker funds have outperformed most active funds across the past decade. That said, past performance is not a guide to future returns, so there’s always a possibility that picture could change.

In some cases, active funds can be a helpful way to bring diversification to a portfolio. For most tracker funds, the largest companies will account for the largest chunk of assets. But if just a few companies are disproportionately bigger, it means the performance of your fund is largely reliant on those names, creating concentration risk. Tracker funds also don’t have limits on how much money can go towards a specific sector or region. For example, a global fund tracking the MSCI World would currently have over 70% of its assets in the US, and nearly 30% in technology stocks.

Active managers have more control over this type of concentration, along with regulations to follow. Part of the regulation of active funds available for sale in the UK is the 5/10/40 rule, which means that no more than 10% of a fund’s money can be in a single stock, and the top five stocks can’t make up over 40% of the allocation. Most tracker funds are exempt from this rule.

Fund managers can also monitor for themes if they worry certain parts of the market are growing too quickly or becoming too dominant. For example, an active manager may choose to have less exposure to AI companies than a tracker fund because they want to mitigate the risk for their investors of the AI trend being a bubble which eventually bursts.

Do regions matter?

Another consideration for active versus tracker funds is where you plan to invest. Some markets seem to present more opportunity for active managers to outperform than others.

The US, for example, has established itself as a market where it’s difficult for active managers to outperform their tracker counterparts. It’s the largest market in the world, which means it is well-traded and the companies are covered by a plethora of research analysts.

Active managers succeed by finding ‘market inefficiencies’, which is a fancy way of saying certain companies are trading at a lower price than they should be. Because there are so many eyes on the US market, it’s difficult to see something unique, and in the past decade, just 13% of active managers investing in the region have outmatched their benchmark, according to AJ Bell research.

The level of outperformance in emerging markets has been much higher, with 48% of active managers surpassing the benchmark in the past decade. There are several factors that play into this trend, but one reason is that emerging markets tend to be much less efficient. They are smaller, and have fewer analysts researching companies, so it’s easier for managers to spot something appealing.

Emerging markets also have a high amount of stock concentration, so some investors might prefer the diversity of an active option. For example, chip specialist Taiwan Semiconductor makes up nearly 15% of the MSCI Emerging Markets index and electronics group Samsung accounts for another 8%. If investors are looking for a broader range of companies, they may want to explore active options.

Being contrarian

Certain fund managers choose stocks with a strategy that goes directly against the logic of an index.

Contrarian fund managers tend to invest against the market. They might take a different view on macroeconomic conditions, and invest accordingly, or they might look for stocks unloved by the market, but where they see potential. This can be an effective way for investors to diversify their portfolio and possibly offer a bit of downside protection in a future market sell-off.

One of the simplest ways to check if a fund is truly contrarian is by looking at its top holdings. If they are similar to those of the index for that region, the fund won’t be contrarian and means you would get similar exposure with an index fund.

Not convinced? You don’t need to be

Active funds appeal to certain investors, but they aren’t the right fit for everyone. Fortunately, you can still have diversity without them.

One method is looking into equal-weighted funds, which hold the same companies as a traditional index fund, but allocate the money equally between the holdings instead of divvying it up depending on market cap (size).

You can also find value-themed tracker funds that use an algorithm to determine if the company is undervalued by a typical index standard. These types of tracker funds tend to have higher charges, but still less than the typical active alternatives.

There’s also the option to be ‘actively passive’, which is what we do in the AJ Bell funds. Our team looks at each region and determines how much we’d like to allocate, factoring in expected returns, geopolitical risks and regional concentration to name a few. We then use passive funds to get the desired, efficient and low-cost, exposure.

If all this feels like a lot to consider on your own, you can always choose to invest through a multi-asset fund so someone else handles the asset allocation for you. Or, if you feel comfortable, you can choose the funds yourself. Our Favourite funds list can be a helpful starting point to find active and tracker funds that have been researched by our team, and where we think they have a great chance of delivering their investment objectives over the long term.

Related news

Shares Magazine

Paul Angell, AJ Bell Head of Investment Research, says:

Do regions matter?

Being contrarian

Not convinced? You don’t need to be

Paul Angell: Head of Investment Research