EquitiesJun 13 2016

Big decline in potential closet tracker portfolios

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Big decline in potential closet tracker portfolios

The number of potential closet trackers identified by Investment Adviser research has declined substantially in the past 12 months, from 15 in 2015 to just four.

This year’s list has two funds in the IA UK All Companies sector that fall into the metric, while there is one from the Global Emerging Markets group and one from the Asia Pacific ex Japan category. All four of the funds identified make the list by the smallest of margins and all emphasise they are not closet tracker funds.

A spokesperson for Dimensional Fund Advisors, which has two funds in the list – Dimensional UK Core Equity and Dimensional Emerging Markets Core Equity – explains the process of these vehicles is systematic.

“The point of our Core funds is to give investors market-wide exposure, with emphasis on the dimensions of higher expected return, size, value and profitability,” he says.

The Columbia Threadneedle fund just falls into the metric, with a spokesperson for the firm pointing out: “The Threadneedle Asia fund’s investment philosophy focuses on bottom-up stock selection with the aim of delivering above-average returns while controlling risk.

“Over the past three years the fund has performed in the top 32 per cent among its peers and has beaten the benchmark index return by a significant margin.

“Active stock selection drove 70 per cent of the three-year outperformance and the three-year information ratio is above the peer group average. This shows the fund is clearly delivering its objective of strong risk-adjusted returns in a volatile market environment.”

The metric: How we worked it out

Using data from Morningstar, we looked at all the funds in the Investment Association UK All Companies, Europe ex UK, Japan, Global Emerging Markets, North America, Asia Pacific ex Japan and Global sectors to identify actively managed funds with an annualised R-squared value of 0.95 or more for the three years to April 30 2016. This limit is based on the average R-Squared value for all passive funds within the sector.

The annualised tracking error for the same period was added to show how closely aligned the funds have been to their respective benchmarks. The cut-off point was based on the average tracking error of tracker funds in that IA sector. The funds were then analysed using ‘active share’. In this report, portfolios with an active share of 60 per cent or less are considered to be potential closet trackers.

Investment Adviser compared the average three year performance of these funds with their tracker peers, sector and index. Individual funds can outperform or underperform for a variety of reasons such as stock selection, fees, cash holdings and manager changes.

The funds in the table are sorted by sector, and efforts have been made to remove funds with the stated aim of tracking an index or any institutional funds, although some may have an institutional bias. All companies on the list were given the opportunity to respond.

A spokesperson for JPMorgan Asset Management (JPMAM) explains the JPM UK Equity Core fund is “explicitly a low active risk fund with a total expense ratio of 40 basis points in the C-share class and is designed to have a low tracking error”.

She adds: “The fund’s low tracking error forms the foundation of a tightly controlled risk framework that the investment team actively overlays with JPMAM’s behavioural finance process. The goal is to deliver alpha, net of fees, on a consistent and risk controlled basis. The track record demonstrates that it has been highly successful at achieving this objective.”

Research into closet trackers has grown more popular, with Morningstar recently releasing a study of the active share of European large-cap funds between 2005 and 2015 that shows 20.2 per cent are so-called ‘closet indexers’ with an active share of less than 60 per cent. But it notes the proportion of closet indexers has been falling in recent years.

So what is behind this decline?

Tom Poulter, investment research analyst at Square Mile Consulting, suggests there could be a number of reasons. One possible factor could be differences in the timing of the pricing of indices and passive funds – intraday or end of day – that can create considerable differentiation in tracking errors, which could affect the cut-off point for identifying closet trackers.

Closet trackers: Definitions

R-squared: A statistical measure that represents the percentage of a fund’s movements that are related to a benchmark index. In theory, the more actively managed the fund, the lower the R-squared. Index trackers carry an R-squared value of 95-100 per cent.

Tracking error: The typical tracking error of an index tracker should be 0 per cent, but depending on the method of tracking it can be slightly higher, as any changes to the index need to be reflected in the fund by buying and selling appropriate stocks.

Active share: This measures the share of a portfolio’s holdings that differs from the holdings in the benchmark. An active share of 100 per cent implies zero overlap with the benchmark.

Another possible driver is the volatility in sectors, such as resources, that has caused managers to avoid these areas and therefore increase their active share.

Mr Poulter notes: “Within the UK a lot of the managers have avoided the oil and gas sector, [and] as it makes up roughly 12 per cent of the index [that can be quite an active move]. In global emerging markets a lot of people have been avoiding Brazil because of the political problems.”

He adds the correlation between sectors in 2015 was a lot higher than in this year – “if you remove oil and gas it is a bigger call this year”.

Ben Willis, investment manager and head of research at Whitechurch Securities, says that avoiding certain areas can affect the level of beta.

“There is less value dispersion within equity markets generally, except for the resource sectors, which have had a torrid time and are looking cheap relatively,” he says. “However, as the fortunes of these areas of the market are largely out of their control many managers are avoiding these areas, despite current valuations. Within the UK the mining and oil and gas sectors still make a sizeable weight and if managers are avoiding these areas then their funds will display less beta.

“Another factor could be costs. The industry has become very cost conscious and this has seen a rise in the demand for passives. As such, investors are not prepared to pay up for actively managed funds that are actually closet trackers.

“This is why we have seen active share come to the fore, so that investors can appreciate the fund is being actively managed compared with the broader market/benchmark, and therefore justify higher costs. This could also be a contributory factor for a change in management style.”

What to look for

The European Securities and Markets Authority (ESMA) released its own report into closet indexers, using a number of metrics, including a similar combination to the Investment Adviser research of an R-squared figure above 95, an active share below 55 and a tracking error of less than 3 per cent. This suggested potentially 5 per cent of the sample of 1,251 Ucits funds could be closet indexers.

But while the issue is becoming more prominent, more still needs to be done, with Better Finance, the European Federation of Investors and Financial Services Users, calling for organisations such as ESMA to name the funds that fall into these closet indexer metrics.

Arnaud Houdmont, chief communications officer at Better Finance, says: “Regulators need to publicly disclose those funds that are marketed and priced as being actively managed but that in reality merely hug or shadow an index. Fund providers need to provide more information on the funds’ performances against their respective benchmarks.

“Funds whose performance does not deviate from their benchmarks should clearly be labelled as passive and fund providers should adapt fees accordingly.”

Darius McDermott, managing director of Chelsea Financial Services, notes the falling numbers indicates closest trackers may be less of an issue than people think, but notes that while more active managers are talking about their active share, the underlying investments are key.

“High active share doesn’t necessarily translate to higher performance if the stocks are bad. When it comes to the reduction in number [of closet trackers], it’s unlikely to be a particular sector such as mining. It is perhaps more due to the fact that mega caps are out of favour, and if managers are avoiding these their active share will rise immediately.”

Laith Khalaf, senior analyst at Hargreaves Lansdown, says many managers probably look more active given the volatile performance of mega caps, in particular oil, mining and banks.

“Managers are generally loath to hold more than a couple of per cent of their portfolio in one single stock and so the big hitters in the FTSE tend to be under-represented in portfolios. I think there is a gradual shift away from closet-tracker products because they are getting pinched by genuine tracker funds on price and by more active funds on performance.

“There is still a lot of money invested in closet trackers, many of which were set up years ago and are simply doing what they say on the tin. Many investors hardly ever review their pensions and investment plans and consequently end up holding on to these lacklustre funds for years.”

Nyree Stewart is features editor at Investment Adviser