ActiveMar 13 2017

How to tell if a fund is a closet tracker 

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How to tell if a fund is a closet tracker 

An asset management boutique has explained how investors can work out if a fund is truly active, in light of the increased scrutiny on funds which charge high fees for closely mirroring the index.

In April last year, the Financial Conduct Authority revealed that it was planning to crack down on so-called closet trackers to try to ensure investors are getting value for money.

The financial watchdog said some investment groups were failing to disclose where funds were using an approach which was heavily linked to indices.

This doesn't mean that investors should necessarily plump for funds with the highest active share ratio.Paul Mumford

Speaking to FTAdviser, Paul Mumford, fund manager at Cavendish Asset Management, said: “It has long been known that many active managers simply do not have the skill and judgment to beat the market over the long haul, hence the rise of passives in the first place.” 

Past performance, he said, is an important metric for investors to consider when trying to identify the handful of fund managers who can beat the market.

But he said there is a lesser-known metric that savvy investors should start paying more attention to, which is the active share ratio.

The active share ratio essentially measures the extent to which a fund tries to beat a benchmark by deviating from it.

It will range between zero, which is a complete tracker, and 100, which is a portfolio devoid of any index stocks whatsoever. 

Mr Mumford admitted that some funds simply fail to beat the benchmark by making the wrong calls, but said some don't stray far from what an equivalent passive tracker would hold.

“It's one thing to pay someone a fee to try, but fail, and another thing to pay someone a fee who then doesn't even try at all,” he said.

The FCA scrutiny was part prompted by a report from the European Securities and Markets Authority (Esma) last year which found that up to a sixth of all active products across Europe could be characterised as closet trackers.

Recently, campaign group Better Finance published a list of potential tracker funds.

Esma has defined ‘closet trackers’ as those with an active share ratio of 60 or less, which the Cavendish manager said are funds which should simply be avoided because the extra fees cannot be justified. 

But he also said many investors fail to realise how much variance there is above the 60 ratio point too.

“There is a big difference between a fund with an active share ratio of 70 and one with 98, for example; these funds are effectively set up to do different things and represent different investment propositions.

“This doesn't mean that investors should necessarily plump for funds with the highest active share ratio - there are many other factors to consider.” 

Mr Mumford said the active share ratio represents another dimension of risk by indicating the extent an investor trusts the fund manager to go against the crowd to try to beat the crowd.

“For investors looking to find funds that can consistently outperform benchmarks, taking a look at active share ratios in addition to past performance isn’t a bad place to start.”

Mr Mumford said active share ratio is something investors should "generally consider, not as a stand-alone metric, but alongside other traditional metrics such as performance".

However, a spokesman for Henderson Global Investors said there are a number of things to be wary of when looking at active share ratio, pointing out the measure should not necessarily be used to compare funds and could in fact mask risks.

Factors such as stock size, volatility and correlations are ignored in the calculation of active share, therefore meaning it is possible to have two portfolios with the same active share but very different risk profiles.

The fund group's spokesman also warned that it is easier to have a higher active share in some markets compared to others, which might lead to the misleading interpretation that fund managers are more active than others. 

For example, the weighting of some indices are skewed towards mega cap stocks, yet might have a large selection of mid or small cap stocks. 

Most active fund managers will see their active share move up and down when they make changes to their portfolios, meaning investors should be careful when looking at a fund in a snapshot of time.

A spokesman for Henderson said a high active share could be a danger sign because the benchmark should act as a reference point to help give an idea of a portfolio’s relative performance. 

“Overall, we believe active share is a potentially misleading metric, particularly if used in isolation or when some or all of the above issues are relevant.” 

katherine.denham@ft.com