Investing is an activity fraught with uncertainty and is all about taking risks on the expectation of a return.
We are constantly being reminded that past performance is not a guide to the future, although investors can take steps to minimise the ignorance of the risks assumed.
The growing popularity of passive investing in the past decade has been partly predicated on the high level of transparency associated with the management of passive funds compared with the active side of the industry.
Passive vehicles, particularly exchange-traded funds, have been the subject of close scrutiny by regulatory bodies, international research groups and media commentators.
The passive industry’s response to this scrutiny has been one of maximising transparency in all aspects of fund management, including comprehensive, regularly updated and easily accessible information of fund components and ancillary operations, such as securities lending.
Of course, by virtue of simply tracking an index, passive managers are not under pressure to keep information on fund holdings away from public eyes. There is nothing to hide. The benefit for investors is one of having full information to help them make an investment decision.
The same cannot be said for active managers, who routinely justify non-disclosure on the basis of protecting their ideas from competitors.
While accepting the validity of this argument, the reality for investors in actively managed funds is that in many instances they are left in the dark as to what managers are doing with their money. Ultimately, this may make them unable to properly assess if the fees paid are justified.
Finding out an active manager lost you money because of an ill-fated bet on Greece only when you get your annual statement is not particularly helpful.
However, the need for more transparency is not only justified for the eventuality of extreme market events – take the issue of index hugging by active fund managers.
There are instances when it makes sense for active managers to just track the market if they feel it is in the interest of fund holders. The problem arises when market tracking within active portfolios becomes the norm rather than the exception.
In that situation, investors might as well save plenty in management fees – and thus enhance potential returns – by simply buying the low-cost passive alternatives. But to do that they first need to have the means of finding out whether their active manager is a closet indexer.
The issue of index hugging is one that regulatory bodies across Europe are slowly waking up to. And rightly so, as it is one of the main problems investors face owing to the lack of transparency.
Demanding active managers to fully disclose their investment actions on a real-time basis is not a realistic proposition.
However, insisting they routinely reveal their vehicles’ present and historical active share – the percentage of the portfolio that differs from the benchmark – is realistic.
The active share should not be taken as the only indicator to make a firm judgement on whether to invest in an active fund. But making the information available will help investors decide whether paying a high management fee is justified.
Jose Garcia-Zarate is senior passive fund analyst at Morningstar
