Investors face an “epidemic” of funds charging for active management while tracking the benchmark, according to a report by SCM Direct, which calls for widespread change in the asset management industry.
The group is now calling for the British public to take legal action against UK fund groups that are marketing funds as being actively managed but fail to carry this out in practice, as well as urging the regulator to step in and demand more transparency for investors.
Gina Miller, co-founder of SCM Group, said: “Earlier this year we produced our second report on the growing practice by active funds of closet indexing – which in our view is nothing short of fraudulent behaviour.”
“Yet, the FCA [Financial Conduct Authority] remains silent whilst regulators and governments around the world are taking action – for example Denmark, Sweden, US, Australia and ESMA. When you consider that [FCA chief executive] Martin Wheatley highlighted this practice in September 2013 as being of grave concern, it is a total disgrace that investors continue to be hoodwinked.”
The report argues that 36 per cent of UK equity funds which claim to be actively-managed can be classed as ‘closet trackers’ under the Yale School of Management’s definition, which says ‘closet indexers’ are funds with an active share of 60 per cent or less.
What’s more, the report found that total assets under management in these funds amount to £136bn and 10 of the funds with the lowest active shares underperformed the market by an average of 2.8 per cent in 2014.
The below graph shows the performance of UK funds last year and their active shares. It shows that a high active share is no guarantee to outperformance (as a manager can always make the ‘wrong’ investments), but a fund with an active share below 50 has a much greater chance of lagging the index.
Active share vs performance in 2014
Source: SCM Direct
SCM says if investors had chosen index equivalents as opposed to the 10 funds with the lowest active share, they could have saved a collective £346m in underperformance last year alone. 
“These latest findings from SCM Direct confirm its previous findings in 2013, namely that UK investors appear to have been mis-sold on a grand scale and that the UK regulator can no longer turn a complete blind eye,” the report states.
“The fact that 36 per cent of UK retail funds have been sold to investors under false pretences not only breaches the Financial Conduct Authority’s over-riding principles for fund management companies that ‘firms must conduct their business with integrity, and communicate information in a way that is clear, fair and not misleading’, it is also nothing short of fraudulent.”
As such, SCM is calling for the FCA to force funds to disclose their active share on their factsheets and for fees to fairly reflect a fund’s active share.
Patrick Connolly (pictured), head of communications at Chase de Vere, said: “The investment industry has come a long way in terms of transparency. You can usually get far more information than you would have been able to in the past and that’s very positive, but the flipside is that there is still more that needs to be done.”
“Active share information is useful and companies should make this information available, albeit it would be a mistake to think that just because you’ve got a higher number it’s better. In some cases it could signify managers making lots of calls and perhaps taking more risks and getting things wrong.”
“I think information such as this is fine and useful, and should be made available. But it is just a case of looking at that number and understanding what’s behind it.”
However, SCM’s report argued that hardly anything has changed over the last couple of years, especially seeing as their September 2013 report was ignored by the FCA in a move that was described as “astonishing”.
It also noted that the Swedish Shareholders’ Association, the world’s largest network of retail investors, saw more than 2,000 people sign up to a class action last year against a Scandinavian fund manager in believes is closet indexing.
AXA Wealth’s Adrian Lowcock says that it is not always appropriate to release an active share figure and that the movement could lead to an over-emphasis on active share.
“I think active share has become a bit of a catch-all for doing the right thing and, while it can be useful to identify fund managers who are claiming to be active, you don’t need to have a high active share to be a good active manager. I think you have to be very careful about how active share is used,” he explained.
“Funds with a low active share have no motivation to publish one because they could get criticised for having a low one, when it may not actually be a bad thing. It all comes back to what the fund does.”
“The transparency issue is always a case of weighing up the transparency with whether you’re going to be treated fairly. It’s an extra bit of data that is useful but it isn’t the solution to all our woes.”
The report also calls for funds to release a full list of their holdings every quarter, which is a rule that the US has had in place since 2004.
In contrast, most UK funds only release a full report of their holdings annually, which some investors argue is not enough to sufficiently monitor the true risk exposure of a fund.
“You can understand why investors want to see the transparency of it, but what are they getting out of it?” Lowcock argued.
“A majority of investors want to see performance and they want to see a fund that outperforms the market over the medium and longer term.”
“You’re always going to get a small group of investors that are interested in seeing the detail of the fund, but most people are more interested in seeing whether the fund manager is doing what they’ve promised and whether they’re delivering on return. So for a lot of people seeing the full exposure won’t really achieve much.”
“There are a lot of arguments as to why fund managers may not want full transparency. It could be they’re trying to dispose of shares or trying to build up those shares. Having full knowledge of all that at the time they’re trying to do it could distort share prices and make it more difficult for them to actively manage the fund and achieve the above-benchmark returns that they want to.”
However, Connolly believes that it won’t be long before the UK follows in the footsteps of Spain, Sweden and Taiwan, who require all fund managers to divulge their total holdings at least twice a year.
“I think we’re moving that way, it’s just not happening overnight,” he said.
“We’re seeing more and more transparency in terms of charges, we’re seeing more transparency in terms of holdings. There is still some way to go. Whether managers will be happy to give their full list of holdings I’m not so sure, but there is definitely more that they should be doing.”
In an article next week, FE Trustnet will be exploring some of the funds that have the lowest active shares and have significantly underperformed the index.
