The regulator also noted that more needed to be done to educate investors about absolute return funds and their performance.
In its Asset Management Market Study published yesterday, the FCA claimed that £109bn was held in “partly active” funds. The study, published earlier in the week, found that some investors “appear to be paying ‘active’ prices for products that are only partly active.”
“Many investors in expensive ‘partly active’ products would be likely to achieve greater value for money by switching to a cheaper passive fund in the same investment category,” it noted.
While industry respondents agreed with the regulator over concerns that funds closely mirroring the benchmark did not serve investor interests well, they did raise issues over the FCA’s method of determining which funds are partly active.
In its interim report published in November, the regulator noted that “there are a large number of active funds which have a similar tracking error to passive funds”, as shown by the chart below.
Source: FCA
Asset managers claimed that active share and tracking error were “not accurate proxies for partly active funds”.
They also warned on the risk of mistakenly labelling genuinely active funds as partly active, while noting that the advantages of active management were not captured by analysis of cost and tracking error.
The regulator noted: “We agree that there are various methods to determine how active a fund is, and that higher tracking error does not necessarily lead to higher returns and lower tracking error to lower returns.
“We agree that neither tracking error nor active share should be the sole basis to identify partly active funds. However we continue to be concerned that over £100bn is in funds that appear to closely follow the market but are charging ‘active’ prices.”
Respondents further suggested to the regulator that concerns around partly active funds are best addressed through improved disclosure of fund objectives and costs.
“If an investor wants a fund manager to be taking decisions that move their holdings further away from the benchmark, they should be able to identify which products offer this,” the FCA report noted.
“We want to be sure that investors are clearer about what they are paying and what the fund is offering in return.
“In addition, we consider that our remedy to strengthen fund governance, will encourage firms to consider whether those funds that closely replicate the market but charge high fees, deliver value for money.”
Paul Mumford, senior investment manager at Cavendish Asset Management (pictured), said: “From our point of view we’ve always been an active investor and always felt that passive investors should be charging less.”
Mumford said the FCA’s estimate of the amount held in partly active funds suggest that some active managers aren’t putting as much work into managing money as truly active managers.
The veteran investor agreed with the regulator over calls for fund managers to make the investment objective of funds clearer for investors and noted that the same should apply to benchmarks.
“[Fund managers] should make perfectly clear why it is close to the benchmark,” he added.
Jason Hollands, managing director at financial planning and investment firm Tilney, said: “Although the report paints an image of an industry that lacks competition, in the main investors and advisers have already been clearly casting judgement on these types of poor value for money, fake actively-managed funds.
“This can be seen both through the exponential growth in passives at one end of the market where competition for what is ultimately a commoditised type of product is rightly fee-based, but also the evidence from the actively-managed funds industry where performance-based competition is key.
Hollands added: “The actively-managed funds which have been hoovering up money from investors have not been dull, benchmark aware products, but those managed by proven investors like Terry Smith, Neil Woodford and Nick Train who typically take an unconstrained and high conviction approach and who can justify their fees through the excess returns they have generated over and above the indices over the longer term.”
The regulator’s study also highlighted issues over absolute return funds, noting that respondents to the study had “broadly agreed” with its analysis that there are problems in the way that firms explain absolute return funds.
Last year proved a difficult one for some strategies in the IA Targeted Absolute Return sector when just over a third of funds recorded a loss.
IA Targeted Absolute Return sector performance vs annualised volatility over 1yr
Source: FE Analytics
However, the strategies have continued to see inflows. The sector was the best-selling for the past six quarters, according to the most recently available information from the Investment Association, and has AUM of around £79bn.
Despite their popularity, issues over how to accurately and clearly explain a fund’s target return and provide benchmarks were raised.
“We agree with respondents that absolute return funds can fulfil a role for investors,” the regulator noted. “Absolute return funds also continue to be popular with investors.
“We are still concerned with the way that absolute return funds, and particularly their performance, are understood by investors.
“We are concerned that many absolute return funds do not report their performance against the relevant target return.
“Performance for some funds is shown against cash alone, despite, for example, having a ‘cash + 2 per cent’ target. This could potentially be misleading investors about the real outperformance compared to expectations.”