Time to clear out the closet

Tom Brown

The terms ‘closet-tracking’ and ‘index-hugging’ seem to have worked their way into the everyday vocabulary of anyone remotely connected to the investment industry.

The debate over whether some funds are masquerading as actively managed when they are actually passive index trackers has been rumbling for some time, but has really come to the fore since the European Securities and Markets Authority’s (ESMA) shocking revelation earlier this year that between 5 and 15 per cent of European funds are potentially misleading investors.

This is bad news for consumer confidence in the industry. There will always be a demand for actively managed funds, index trackers and funds that combine elements of both. However, all funds should say what they do on the tin, and they should then do what they say on the tin. With increased scrutiny from regulators and investors, and competition in the sector ratcheting up, ‘closet’ trackers will not be around for much longer. In fact, closet anything just will not make the cut in the new era of investment management.

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Investors are in large part the real driving force for change. Like everyone else, while interest rates remain very low, people are both looking for their money to work harder and watching the pennies. This is putting greater pressure on managers and advisers to work harder for their fees.

Being able to explain clearly the value of an investment product is an impossible task for advisers if fund managers are not transparent, for example if the product is a closet tracker. But, if advisers consistently ask the right questions, and educate investors to do the same, that alone would go a long way towards clearing out the closet.

The regulators are also playing their part. The Financial Conduct Authority and other national European regulators have all notched up their scrutiny of the investment management sector over the past few years and it looks set to continue, as this year’s Evolving Regulatory Landscape report will illustrate.

The banks were asked tough questions and given firm treatment on their attitudes and practices towards treating customers fairly. It looks like it is now the turn of the investment management sector to feel the same heat. The sector needs to brace itself for a level of regulatory scrutiny it has never before been subject to. We have already seen action taken on inappropriate product descriptions, and that is just the start.

Fund managers will increasingly need to demonstrate that they design, price and market products that are genuinely built around the end-investors’ needs. Advisers and other distributors will not escape scrutiny, and should see it as their role to help facilitate this process. Index-tracking products describing themselves as actively managed and charging commensurate fees do not fit that description.

The final driving force for change is competitive pressure. The whole financial services sector is changing, some aspects quicker than others. But in 10 years’ time we will see a very different landscape to the one we have today. I expect there will be companies and apps that we have not yet anticipated, but even without those, investment is no longer the cosy club it may once have been. Alternative methods of investing, such as DIY platform services, peer-to-peer lending and crowdfunding all give investors the option to research, select and invest in a multitude of assets and in a variety of ways.