The problem of closet trackers, or funds where the portfolio has a very strong resemblance to its underlying benchmark, has not been far from the headlines in recent months. Advocates of true active management have become increasingly vocal that some consumers are paying huge sums of money for the benefit of an actively-managed fund only to get an investment which, well, isn’t.
At the end of 2014 research by Simon Evan-Cook (pictured), senior investment manager on Premier’s multi-asset funds, found some compelling statistics that highlighted how much index-hugging funds are costing their investors.
His ‘Kill the Filler: The Costs of Closet-Tracking’ paper found that nearly 30 per cent of the money in the IMA’s two main UK main equity sectors is held in closet tracker funds.
This amounts to a total of £58bn of investor’s money which is simply mimicking the stock market, but being charged fees for an active service.
Evan-Cook’s research also shows that, in terms of the average annual ongoing charge, investors pay 0.82 per cent more than what is paid by the tracker holders, meaning UK equity funds could potentially save themselves more than £750m each year by switching to a ‘real’ passive.
A report in the FT revealed that the issue of closet trackers will be part of a review into asset management regulation in Sweden. It follows a move by the Swedish Shareholders Association to launch a class-action lawsuit against the country’s second-biggest asset manager, claiming it of miss-sold index-hugging funds to retail investors.
Martin Bamford, managing director of Informed Choice, said: “It will be really interesting to see the outcomes of this investigation in Sweden. European regulators are increasingly sharing best practice, so an investigation in Sweden could well prompt investigations or reviews in other European countries.”
This begs the question: why don’t the rest of Europe follow Sweden’s example and crack down on index-huggers? The answer isn’t a clear-cut as you may think.
Patrick Connolly, head of communications at Chase de Vere, says the important battle is making sure investors understand what they are paying for when they buy a fund, rather than seeking to define exactly what active management is and is not.
He said: “You could make the argument that the rest of Europe needs to take notice of this, but I’m unsure whether this action is required. It would be difficult to impose lower charges on closet-tracking managers because there are some passive funds that have high charges.”
“The problem is people understanding what they’re getting into and that’s the real issue. In terms of the UK, I think it’s sensible that there is a review to looking at investment funds and seeing how they’re run.”
“From our perspective, the approach we take is that we’ll typically invest in pure active funds or in passive funds; we wouldn’t usually invest in closet-tracking funds. But then we understand how funds work and we know what we’re looking for. The danger is that people go into these funds without understanding what they are or what they’re paying for.”
Bamford adds that index-hugging funds are more likely to “disappoint” their investors rather than deliberately mislead them. He would welcome a deeper look into the issue, if only to educate some investors that they can use a cheaper, genuine passive fund.
“Where investors believe they are getting value in return for paying for higher active fund management fees, but the manager is effectively tracking a benchmark, better value can be had elsewhere with a cheaper index tracker fund,” he said.
“It would be good to see the Financial Conduct Authority [FCA] launch a thematic review of closet trackers in the UK, if only to highlight the issues for investors to consider.”
This opinion appears to remain consistent across the board. While very few people support closet-trackers, most agree that the real focus should be on educating investors about their buying choices not restricting them.
Evan-Cook said: “It would be good for investors to have a better understanding [of the market] and I’d prefer to see more information being provided to them, rather than trying to clobber someone with a stick and effectively sue someone for compensation.”
“I would prefer that investor education is improved so they are able to judge for themselves whether a fund is a closet tracker and whether they’re paying too much for it.”
Ben Conway, fund manager at Hawksmoor, added: “This sort of thing shouldn’t be massive news to fund pickers, like us, as through our due diligence we should be able to distinguish which funds are closet trackers and which ones aren’t.”
“However, I think it’s definitely a good thing for retail investors as it would give greater transparency. It should also provide support for smaller funds and that is because as a fund gets bigger and bigger, it is more likely to move close to the benchmark.”
But investors can’t be educated if they don’t have all the information they need on the table. Over the last few months, there’s been a big push for fund managers to publish the active share of their funds and it’s likely that this metric will play a greater role in the active vs passive debate.
Woodford Investment Management, Neptune, Threadneedle and Majedie have already pledged to do this, demonstrating a real drive for transparency in the investment world.
Robin Geffen (pictured), founder and CEO of Neptune Investment Management, says there could be a need for the FCA to ask for active share to be published, to prevent investors from buying funds that charge for active management then simply follow the benchmark.
“There remains in Britain financial institutions that promoted active management products in their shop windows, whilst stashing billions of pounds worth of assets invested in closet trackers under the counter,” he said.
“Surely managers who are truly active would want to disclose their active share figures, to prove they are delivering what their investors pay a premium for.”
“I fear, however, that this is unlikely to happen unless the regulator insists upon it as part of efforts to ensure all customers are treated fairly. Otherwise, investors will remain unsure whether their specific investments are being managed in truly active strategies or not.”
Neptune’s UK Mid Cap, Global Special Situations and Global Alpha funds all have an active share of 94 per cent or over.
However, commentators have stressed that active share alone does not necessarily mean a fund will be truly active, pointing out that funds can still perform poorly even when they look off the benchmark.
Connolly said: “There’s a danger that people naturally just think a higher number is better and that may not be the case. A higher number means the manager is taking a greater risk, which may or may not work.”
“Yes, I think this offers transparency but I think there needs to be some careful thought in terms of how that’s delivered. You don’t want investors who are making their own decision simply looking for the highest active share number that they can find.”
Evan-Cook agrees that there is a risk in trying to boil down active management into a single metric, stressing the need for greater investor knowledge over putting more numbers into a spreadsheet.
“Having a measure like active share would be extremely useful, but accompanying that you would need to have a wider understanding of what an active share is and the risks of having a very active fund relative to a benchmark.”
“There’s a lot of destruction caused by ignorance, unfortunately. So rather than blaming fund groups and trying to sue somebody who people feel they haven’t done as well as they’d hoped, I’d prefer to see investors educated more appropriately so they’re more able to make a decision themselves.”
However, the question still remains as to whether Sweden’s investigation launch will tempt the rest of Europe to follow suit. Connolly says the outcome is unlikely to be much more than improved transparency – which he feels the UK is moving towards anyway.
“I’m not sure what the result of [the investigation] will be other than greater transparency, and we’re seeing greater transparency across the investment fund market,” he said. “We’re seeing this with charges and there’s an argument that we should also see it with how funds are run.”