Active Funds Underperform with High Fees. You might be owning one without realising ...

Do you have a work pension scheme?  Or IFA-managed funds?  Or ever invested into a fund that was advertised?

If so, you are likely to have invested in an active fund.  This matters because you’ll be paying excessive fees for underperformance.

As a former active fund manager, I’ll explain how an active fund is run and reveal secret marketing tricks often used by investment companies to make their performance look better …

This article (video & podcast 👇🏼) will demystify active funds, explain how they work, their fees, returns, and help you understand the impact on your wealth.

You can then take a more informed view to see if you'd like to capture proven, inflation-beating returns of stocks in a more passive, low-cost way without falling for the slick marketing.

Listen to the podcast version on Apple here or on Spotify here. Or watch the video version here.

Why Does This Matter?

Understanding active funds is crucial because of their high fees, alongside the high fees with your pension scheme and IFA.   These fees can be much higher than you might think and can significantly affect your wealth.

One of our clients, Karen, was shocked to learn that out of her £617k in investment gains, £219k was lost to fees.  Karen only got to keep £398k of her own capital.

This shows the importance of being mindful of the impact of fees on your investments.

Download my step-by-step guide to simple but highly effective investing for inflation-beating returns here

What Are Active Funds?

Let’s clarify the jargon to start with.  Funds are a diversified way to own different stocks.  There are Active and Passive Funds.

• Active Funds: are run by fund managers who make active decisions about which stocks to buy.  With the aim of beating the market index (eg FTSE100 index)
• Passive Funds: Also known as tracker funds or index trackers, simply aim to replicate the performance of an index like the FTSE100.

Active funds are branded and often advertised in train stations, by the side of the road, in newspapers and magazines. Names include Baillie Gifford, Jupiter, Schroders, Fundsmith, Scottish Mortgage, St James’ Place etc

Passive funds include iShares, Vanguard, SPDR etc.

CRITICALLY:  in seeking to outperform the index, active funds frequently underperform.   We show evidence of this below.

How to Identify Active Funds

Check the factsheet, which is available on the website of your fund provider, pension plan, or through your IFA. These factsheets provide important details and typically come as 2-page PDFs.

Check if your fund's returns closely track the benchmark comparison on the factsheet. If they do, it may be a tracker. If not, it may be an active fund.

Also check the fees which should be stated in the factsheet. Fees will be labelled TER or OCF and most passive funds have a fee of 0.25%pa or less. Active funds will be higher.

How Do Active Funds Operate?

Active funds employ human fund managers who attempt to deviate from the index in order to outperform it.

For example, while a passive FTSE100 fund might have 9% of its assets in AstraZeneca, an active fund manager might choose to have a different percentage based on their analysis. They decide which stocks to include and in what proportions, often having fewer stocks than an index fund.

As a former active fund manager, this was exactly my job – to run my funds with the express aim of outperforming the index.

Marketing Tricks of Active Funds

Active funds are very profitable.  Their marketing is often very clever, slick and employing various tricks.

One notable trick is called fund farming.  Fund managers ‘grow’ multiple funds in a laboratory setting, expecting that a small percentage will perform exceptionally well. They then heavily market the successful funds, attracting more investments – without showcasing the underperforming ones.   This makes the performance appear much better than the reality.

Higher Fees (+hidden fees) 

Active funds come with higher fees compared to passive funds. While passive funds may charge up to 0.25% pa, active funds can charge multiples of this – anywhere between 0.5% to 2%+ pa.

These is just the headline fee.  Additionally, there might be initial and exit fees, high trading costs, and other hidden fees. These all add up and compound negatively, significantly impacting your net returns.

Poor Performance of Active Funds

The performance of active funds often doesn’t justify their high fees. Studies like the “Spot the Dog” and the SPIVA index consistently show that a significant majority of active funds underperform. For instance, 88% of U.S. active funds have underperformed the index.  That number is higher for UK managers.

High-Profile Examples of Active Funds

• Fundsmith: Despite having a good reputation, it has underperformed a comparable passive index for a few years.
• Scottish Mortgage: Initially a market darling, it has significant underperformed over the past few years.
• Woodford Fund: Perhaps the worst example, Neil Woodford’s fund collapsed, causing massive losses for investors despite heavy marketing and promotion.

Conclusion

In summary, don’t get swayed by slick, clever marketing or brand names.  Lower costs often correlate with better performance in the investment industry.

Choose passive funds which are simpler and avoid active funds to help you compound returns more effectively.

For more on how to invest wisely, check out our Investment Academy.

Stay informed, invest wisely, and ensure your retirement funds are working for you, and not someone else.