From Special Report: Investment Adviser Mid-Year Monitor
Outing closet trackers
Investment Adviser has identified the sectors where the number of closet trackers has increased
The number of ‘benchmark hugging’ funds – or closet trackers – is on the increase, Investment Adviser’s third annual Mid-Year Monitor reveals.
In 2010, Investment Adviser devised a metric using Morningstar data and identified 19 potential closet trackers in the IMA UK All Companies sector. In 2011, this dropped by just one to 18 funds, including products from big names such as Henderson Global Investors, Santander Asset Management and Standard Life Investments.
Last year also saw the report extended to include the IMA North America, Global Emerging Markets and Europe excluding UK sectors, uncovering a further two offenders in the first of these sectors.
This year, however, has seen the number of closet trackers in the IMA UK All Companies sector leap to 24. Investment Adviser has also discovered that nine funds exist within the IMA Global Emerging Markets sector with high R-Squared values and low tracking errors, metrics which indicate less divergence from the funds’ benchmark.
In-depth detail on how the metric works is given on the page opposite, but, simply put, it is based on funds with an annualised tracking error of less than 4.55 and an R-Squared value (see definitions) of 95 per cent and above. The list of those affected includes heavyweight houses such as Aberdeen Asset Management, Franklin Templeton and JPMorgan Asset Management.
To throw additional weight behind the research in this year’s report, the potential closet trackers have been further analysed using a measure referred to as ‘active share’.
Devised by Martijn Cremers and Antti Petajisto of the Yale School of Management, this measures the share of the portfolio holdings that differ from the holdings in a fund’s benchmark index.
An active share of 100 per cent implies zero overlap with the benchmark. Index funds have an active share of zero per cent. For the purpose of this report, an active share below 60 per cent is classed as a closet tracker.
Starting with the IMA UK All Companies sector, the most tracker-like fund in this year’s list is the £268.6m NFU UK Growth fund, managed by Nigel Yates, with a tracking error of 1.65, an R-Squared value of 99.43 per cent and an active share totalling just 24.14 per cent.
In spite of carrying a total expense ratio (TER) of 1.52 per cent, the fund failed to outperform the FTSE All-Share over five years to May 9. In fact, it lost its investors 1.33 per cent, while the index gained 1.36 per cent.
Over a three-year period, the product did only marginally better than the index, returning 40.97 per cent, compared with a return for the index of 39.91 per cent to May 9.
In the fund manager’s absence, NFU Mutual’s chief investment manager Paul Glover explains: “The NFU Mutual Investment team manage in excess of £12bn across a mixture of in-house and retail funds and asset classes. All of the funds are challenged with outperforming their respective benchmarks (index or peer group as appropriate) over a long-term period. None of our funds are designed to be merely tracking an index and this has certainly not been our experience.
“The UK Growth fund has similar characteristics to our other UK portfolios, but does seem to have ended up being the closest to the index over recent years. It may be a bit of a statistical quirk as the sector and stock weightings certainly differ from the index. The fund entered the financial crisis with a relatively defensive portfolio, and as the market fell, the fund did consciously add risk and this did have the effect of moving the fund closer to the index over the past three years. The fund is now moving away from the index again and is reducing holdings and taking more active positions, so correlation going forward should reduce again.
“A significant part of the UK Growth fund is held indirectly as part of the managed funds that most of our retail clients buy, and these funds are actively managed at both the asset allocation and stock selection levels.”
According to Mr Glover, while the fund’s annual management charge currently stands at 1.25 per cent, it will be reduced after the RDR.
Of the funds within that sector that met the closet tracker criteria, Scottish Widows Investment Partnership’s (Swip) £203m MM UK Equity Growth fund carries the highest TER at 1.82 per cent, with a tracking error of 4.49 and an R-Squared value of 96. Furthermore, this fund has an active share of 42.09 per cent.
The fund, which according to its factsheet seeks to “consistently add value above the total return of the FTSE All-share index through active stock selection in a risk-controlled framework”, has failed to beat its benchmark over three and five years to May 9.
Over three years, the fund returned 38.93 per cent, compared with the FTSE All-Share’s 39.91 per cent return. Over five years, the fund underperformed the index by 7.02 percentage points, losing its investors 5.66 per cent.
Of the funds identified by the metric with the largest assets under management, the closet trackers include the £3.82bn Halifax UK Growth, the £1.24bn Santander UK Growth, the £682.1m Santander Premium UK Equity, the £239.3m JPMorgan UK Managed Equity and the £228.8m Threadneedle UK Select funds.
The active share percentage of these funds ranges from 18.19 per cent for the Halifax fund to 58.85 per cent for the Threadneedle portfolio.
Mark Hall, portfolio manager of the Franklin UK Select fund, which also appeared in the list alongside the Franklin Templeton UK Blue Chip fund, says his portfolio has had a greater correlation to the FTSE All-Share in the past three years as a result of a strategic decision to move into more liquid defensive stocks such as tobacco and pharmaceuticals.
He adds: “These types of stocks tend to be large FTSE 100 companies and have large weightings within the overall index – more than half the market cap of the index is in 20 or so stocks. That said, the motivation was to protect capital not to track an index. If you looked at R-Squared over multiple three year periods (rather than one) this would demonstrate a significantly reduced correlation to the benchmark.
“Regardless of that, the fund is actually 46 per cent actively positioned, and is 120th out of 272 in terms of performance within its peer group over the considered time period. I continue to examine where I can refocus in the less benchmark-orientated mid and small-cap space where there are compelling opportunities.”
Meanwhile, Colin Morton, portfolio manager on the Franklin UK Blue Chip fund, which has an active share of 45.06 per cent, according to Morningstar, argues that the nature of UK blue-chip funds means that there will always be some representation of the index, as UK blue-chip stocks are predominately large companies within the FTSE 100 with significant benchmark weightings.
“The reality is that the Franklin UK Blue Chip fund is currently composed of 41 per cent active money relative to the FTSE All-Share, an inherent deviation from the index,” he says. “The fund is also second quartile when measured against its peer group over the considered time period. The financial crisis in 2008 also brought a period of de-risking when we looked to more defensive liquid stocks that have higher benchmark weightings. It is important to emphasise that there will clearly always be some correlation between a UK equities portfolio and the UK benchmark, but what we seek to achieve is steady but significant compound returns over time that will considerably outperform the benchmark, while limiting downside risk.”
In the IMA Global Emerging Markets sector, the nine-strong list of potential closet trackers include funds from Baring Asset Management, Schroder Investment Management, Swip and Dimensional.
However, when the active share filter is applied, this list is reduced to just three offenders – the Dimensional Emerging Markets Core Equity, Swip Emerging Markets and Scottish Widows Emerging Markets funds.
The most tracker-like fund when the three elements of the metric are combined is the Dimensional fund, with a 3.51 tracking error, an R-Squared value of 98.35 and has 33.67 per cent active share.
In spite of this, however, the fund has outperformed over the long term, delivering 40.67 per cent over three years and 42.93 per cent over five years to May 9. This is compared with the MSCI Emerging Markets index return of 36.66 per cent and 37.88 per cent respectively.
Sam Adams, head of financial adviser services for the UK and Europe at Dimensional Fund Advisors, told Investment Adviser that the firm is comfortable with this particular fund being referred to as a closet tracker.
He says: “Our funds are closer in philosophy to an index fund than they are to active products. We don’t do any stockpicking or market timing and instead we have a position in every stock available as part of the index.”
The fund carries a TER of 0.82 per cent, which is marginally higher than the average tracker fund or exchange traded fund, and while Mr Adams claims that “enhanced tracker” may not be the right term for this fund, it isn’t far off from what it aims to be.
Meanwhile, Swip in particular has been under scrutiny recently following an announcement in April that it is planning to “reposition” its £54bn equities business to focus more on global and specialist funds. According to reports, the move will see some funds merged away and others managed on a more quantitative basis.
Among others, the future of the £201.7m Swip Emerging Markets fund, managed by Iain Fulton and Michelle Wu, was thrown into question.
With a tracking error of 4.2 and an R-Squared value of 97.23, the fund sits firmly within the list of nine emerging market-focused closet tracker funds. Furthermore, in spite of having a TER of 1.78 per cent, the fund only has an active share of 49.63 per cent and has consistently underperformed both the index and the peer group.
Over three years, the fund delivered a 26.54 per cent return, compared with the MSCI Emerging Market index return of 36.66 per cent and a peer group average of 35.55 per cent. Over five years, it has gained 18.22 per cent, compared with 37.88 per cent and 28.87 per cent for the index and sector respectively.
The RDR’s focus on investment costs is likely to result in rising investor demand for managers who genuinely make every effort to outperform, turning the spotlight onto active fund managers who do not deviate greatly from benchmark indices.
At a recent event hosted by Investment Adviser, Phil Reid, head of UK external distribution at HSBC Global Asset Management, claimed that the actively managed fund market will evolve because “it will be forced to”, saying: “There will be an increased scrutiny on active managers and if someone is a pseudo-tracker we will see money come out.”
Peter Toogood, investment services director at Morningstar OBSR, supported this, suggesting that some fund managers would absorb an enormous amount of money simply because “the talent pool is limited”.
He told an audience of IFAs: “There is a very limited number of people that can do it – you could not find 1,000 competent active fund managers.”
Jenny Lowe is features editor at Investment Adviser
-R-Squared: in theory, the more actively managed the fund, the lower the R-Squared figure. The figures for index trackers are invariably
95-100 per cent
-Tracking error: the typical tracking error of an index tracker in theory should be 0 per cent, but depending on the fund manager’s method of tracking it can be slightly higher, as any changes to the index need to be reflected in the fund by the manager buying and selling the appropriate stocks
-Total Expense Ratio: the total annual cost of a fund including management fees but not including initial charges
-Active share: a new measure created by Martijn Cremers and Antti Petajisto from the Yale School of Management, which measures the share of portfolio holdings that differ from the benchmark index holdings