The European Securities and Markets Authority (Esma), the Europe-wide body that is the guardian of a single rule book for EU financial markets, has raised concerns about the practice of closet indexing. It found that up to 15 per cent of active equity funds in its study of 2,600 funds appeared to just track their underlying market index between 2012 and 2014.
Esma is concerned that investors are paying high fees and not receiving the service or risk/return profile they expect. It said it will continue to work with national regulators to determine further actions, as the analysis gives only a first indication of whether particular funds are closet index trackers. It has suggested that fuller investigations on a fund-by-fund basis will be needed.
Closet indexing, also known as index hugging, refers to the practice of fund managers claiming to manage portfolios actively – and charging high fees – when in reality the fund stays close to – or hugs – an index.
Esma conducted research to determine whether it could find any indication of closet indexing at an EU-wide level following press and customer group concerns. Quantitative metrics, such as the percentage of a Ucits portfolio that does not coincide with the underlying equity benchmark was used – basically, is the fund the same as the index or is the manager taking active bets?
There has already been a class-action lawsuit filed against Sweden’s second-largest fund house, Swedbank Robur, over allegations that it had mis-sold investors closet trackers.
More than 2,500 investors signed up to the lawsuit, which was initiated by the Swedish Shareholders’ Association. And it is not the first time.
A report in 2015 found investors had been overcharged in at least 20 of the world’s largest investment markets. That intensified calls for regulators to put an end to a systemic mis-selling crisis in the fund industry.
The report showed that in two countries – Sweden and Poland – more than half the assets in domestic equity funds had been funnelled towards managers that charge high fees for active management but closely follow their index.
It suggested the phenomenon was also rife in Canada, Finland and Spain, where more than 40 per cent of the assets in local equity funds are in so-called benchmark huggers.
Carl Rosen, chief executive of the Swedish Shareholders Association, said it was “no surprise” that the level of closet tracking was so high in Sweden, a market he described as “dominated by large banks with a strong distribution capacity”.
It seems that investors in Sweden are getting a poor deal – it sounds like a good reason for them to have a strong IFA sector. Or maybe with only 30 stocks in the OMX Industrial Index it is actually quite hard to take an active position?
One major issue for regulators will be trying to prove a manager is a hugger when they have actually been active. What happens if they have met their risk targets? What if the manager was active in the first half of the year and then hugged the index in the second half? Or a manager that was positioned for growth and then moved to value – over the period the net position was the index, but at any point they could have been far from it?
Of course, it will not just be regulators that are annoyed with closet trackers – active managers who are active will be tarred with an “expensive – do little” brush, which may be unjustified.
Research presented by Martijn Cremers and Antti Petajisto at the Yale School of Management introduced the concept of ‘Active Share’, a method of determining the extent of active management being employed by a manager. Interestingly, their studies showed that funds were tending towards lower active share over time. Funds with an active share of less than 60 per cent increased from 1.5 per cent in 1980 to 40.7 per cent in 2003 – and it was not driven by the rise in index funds. Perhaps, unsurprisingly, higher active share was also more prevalent among smaller funds – big funds find it harder to take big bets? (Note: higher active share does not necessarily correlate with higher alpha).
Mr Cremers and Petajisto also looked at tracking error volatility – how the fund deviated from its benchmark – as an alternative measure. The issue is while it does show deviation in performance from the benchmark, it does not look at the underlying holdings.
They created a simple matrix that combined active share with tracking error to produce “Styles of Active Management” (see table 1).
Table 1.
| Diversified stock picking funds – high active share strategies, the holdings and returns of which are closer to the index than the concentrated stock pickers | Concentrated stock picking funds – high active share strategies, the holdings of which deviate most from the index – the most you can differ from the index |
| Closet indexers – low active share strategy that looks very similar to the benchmark index with a low tracking error | Factor bets – low active share strategy in which a manager places oversized bets on a sector the manager projects to produce superior performance |
Interestingly, Mr Cremers and Petajisto discovered that for the period 1990-2009 the closet trackers identified by this method had the worst performance of all active managers – they are, in essence, expensive trackers. And this is why regulators are concerned about the potential for poor outcomes.
Many investors would be happy to pay for active management – so long as it delivers. This brings into question a wider issue of why we pay up-front for active fund management? Surely it would be better to only pay if it works, after the event. But performance fees (at least in Ucits vehicles) are incredibly difficult to deliver.
UK-based advisers and their customers can now access risk-managed passive solutions (tactical asset allocation overlays using passive vehicles) for less than 0.75 per cent including the platform – so why would you pay 1.4 per cent or more for a closet tracker plus the platform?
The rise of index funds has done a good job of outing some of the “dumb alpha” or closet index funds. And a strong adviser community incentivised to look after customer interests may prove to be a powerful tool in making sure that any others are revealed.
Sweden may have discovered that big distribution is expensive, whereas in the UK we have discovered that advice is really valuable. It will be interesting to see what Esma and the FCA discover when they compare UK funds with a pan-European sample.
David Norman is chief executive of TCF Investment
Key points
Esma is concerned that investors are paying high fees and not receiving the service or risk/return profile they expect.
A report in 2015 found investors had been overcharged in at least 20 of the world’s largest investment markets.
UK-based advisers and their customers can now access risk managed passive solutions for less than 0.75 per cent.
