It’s rare to find a subject upon which everyone agrees. But that closet trackers are scoundrels seems to fit the bill.
The case for the defence is missing – largely because for funds to defend themselves would be to ‘out’ themselves. However, as a fund buyer who neither runs, nor has ever bought, a closet tracker, I have no such qualms. Is there a case for the defence?
Trying to prove these funds are worth buying today is a lost cause. They are not. But could managers defend running index-hugging funds in the past? I think they could, which makes the current zeal for retribution seem overdone.
In understanding why such funds exist, there’s a useful parallel in farming development: isolated subsistence farmers who, rather than cultivating one large field, farm a scattering of tiny plots, often miles apart. Otherwise, they face starvation in the one bad year in 10 that their single field fails. These farmers evolved a diversified system that didn’t produce much in the best years but, crucially, didn’t lead to catastrophically low yields in that one bad year.
Closet trackers are the result of similarly Darwinian forces. They came to the fore in the 1990s – shortly after the practice of measuring funds against an index took off.
Most managers soon learned that, while customers enjoyed the years when you handsomely beat the benchmark, they would not forgive even one year when you were significantly behind it. The lesson? Scatter your portfolio as widely as the benchmark to avoid that one bad year.
The criticism of closet trackers is nuanced, however. It is not that hugging an index is bad (although it may well be). The complaints focus on the high fees charged for doing so. Closet trackers do appear poor value for money.
But my own studies of active management reveal they were commonly run by companies that distributed through high-street branches or large sales teams. Such efforts were needed to reach many less financially sophisticated customers. Customers who might otherwise have stuck with cash, despite needing equities’ higher long-term returns more than most.
Unlike buying a fund online today, high street properties and sales teams are costly. So, while closet tracker charges were high, this may not have translated to high margins and, therefore, profiteering.
In the 1990s and early 2000s, there was a significant group of customers who wanted three things from a fund: to conveniently buy it on the high street; to beat the market; and never to significantly underperform that market. The industry’s best answer to this was closet trackers.
Experience has since shown this was an impossible dream: high-street costs weigh on performance, while long-term outperformance often involves short-term pain. Buyers have duly adjusted. Some are abandoning buying from the high street and beating the market. All that remains is the desire never to underperform the market significantly. The industry’s latest best answer is trackers, bought online.
Darwinism never sleeps, however. Closet trackers are dying out, leaving trackers and truly active managers. We should not mourn their passing, but level-headedness is required. This has been part of capitalist evolution, not an industry-wide conspiracy. Using hindsight to punish companies for playing their part in that evolution will only slow it down.
Simon Evan-Cook is senior investment manager, multi-asset funds at Premier Asset Management
