Mutual Funds | Get Your Money's Worth From Managed Mutual Funds

Ever since exchange-traded funds went mainstream, actively managed mutual funds have gotten a bit of a bad rap.

In theory, the idea of paying more to buy into an actively managed fund is reasonable. While an ETF is cheaper, it is also meant to only match the performance of a certain index, not beat it. An actively managed fund, on the other hand, is supposed to benefit from the care and attention of a fund manager and bring investors superior returns.

However, that is often not the case.

"Call me a cynic but you're really taking the company at their word when they say they're actively managed," David O'Leary, director of fund analysis, Canada at Morningstar Research Inc., said in an interview. "It's in their best interest to say they are selling actively managed funds, because then they can charge more."

Many such funds have been dubbed "closet index funds," a derisive term describing products that are advertised as actively managed but in truth mirror their benchmark indices while charging fat management expense ratios.

"As soon as you deviate from an index it becomes actively managed, but meaningfully it could look 99 per cent the same. How're you going to beat a 2.5 per cent fee ratio when 90 per cent of the fund is the same?" O'Leary said.

Morningstar has developed a scoring system called the Industry Sector Concentration (ISC) to rank the equity holdings of mutual funds.

The ISC measures how similar a fund is to its benchmark index based on sector weight, producing a relative score. In general true actively managed funds score 20 or higher, and the most active funds may hit north of 40, O'Leary said.

"The really interesting ones are the funds with a very low ISC score but charge high fees," he said.

Some examples in the Canadian equity space (benchmark is the SP/TSX composite index) include the Acker Finley Canada Focus Fund (MER: 5.44 per cent ISC: 9.79), the Manulife GIFe 1 Sector Rotation Fund (MER: 3.88 per cent ISC: 7. 06), the National Bank Protected Canadian Equity Fund (MER: 3.37 per cent ISC: 5.80) and the IG FI Canadian Equity Fund Class C (MER: 2.89 per cent ISC: 2.70).

It is possible for a fund to be actively managed and have a low score if its sector weightings are very similar to the benchmark but the stocks are different. However, funds with a high ISC score are definitely highly actively managed, he said.

Standouts include the United Canadian Equity Alpha Corp CI F (MER: 1.87 per cent ISC: 29.61), Leith Wheeler Canadian Equity Fund Series B (MER: 1.56 per cent ISC: 28.10) and the RBC Canadian Equity Income Fund Series D (MER: 1.19 per cent ISC: 27.86).

Interestingly one of the highest scoring funds is the iShares Diversified Monthly Income Fund (MER: 0.55 per cent ISC: 38.35) which is actually an ETF. The fund invests in income-producing iShares funds and rebalances each quarter.

However, the ISC is only available on software marketed to investment advisors and is not found on the Morningstar website, in part because retail investors are not asking for the information.

Norman Rothery, author of the Rothery Report, said investors looking to do their own analysis should compare a fund's top holdings and weightings with an index such as the SP/TSX 60. Another option is to compare the amount of turnover in a fund's holdings over time.

"If there's lower turnover in a fund, it speaks to a longer-term orientation and conviction in the manager's philosophy. Also, you're unlikely to encounter high trading costs," Rothery said. "With these things you're really looking for characters, not the bureaucratic managers but people who are looking to perform well."

Managers working for established funds at large institutions have less to gain when "swinging for the fences" as inflows are not likely to rise appreciably but a big miss could seriously harm the fund's reputation, O'Leary said.

A fund's long-term returns can also give a picture of the manager's performance, but investors need to be careful as most managers only stay at a fund for four to five years, O'Leary said.