What a fund promises
Every fund makes a promise in writing: what it will try to do, what it will hold, and what it measures itself against. Reading that promise tells you more than any advert.
The mandate
A fund’s prospectus sets out its objective (for example, to grow over the long term), what it may hold (shares of large European companies, say) and its limits. That is the mandate. The manager may do anything inside it and nothing outside it.
The benchmark
Most funds name an index they compare themselves with, such as a world or European share index. An index fund tries to match it as closely as it can. An active fund tries to beat it, and charges more for the attempt.
Tracking error and active share
Two numbers show how far a fund really strays. Tracking error measures how much its return wanders from the benchmark’s, year by year. Active share measures how much of what it holds differs from the index. A fund with low numbers on both is close to an index fund, whatever it calls itself.
Paying for active, getting an index
In 2016 Europe’s markets regulator, ESMA, looked at about 2,600 share funds and found that between 5% and 15% of them might be "closet trackers": priced as active funds while holding almost the index. It was a first screen, not a verdict on any one fund, but it showed why the numbers matter more than the label.
What the fee gap does over time
Say an index fund and an active fund both earn 6% a year before costs. The index fund costs 0.2% a year, the active one 1.5%. After 20 years, €10,000 has become about €30,900 in the first and €24,100 in the second. The active fund has to beat its benchmark by the whole gap just to come level.
Key takeaways
- A fund’s mandate and benchmark are its promise; read them first.
- Tracking error and active share show how active a fund really is.
- An active fund must beat its benchmark by its extra cost just to come level.