Cracking down on closet trackers

The vast majority of actively managed funds fail to beat the market, and little wonder – many are not even trying. Evidence is mounting that many high-fee funds that purport to be active are in fact little more than closet index trackers.

In March, Norway’s financial regulator accused the country’s biggest bank of selling a closet tracker. The fund in question, which charges a 1.8 per cent annual management fee, “has performed very closely to its benchmark, but is marketed and priced as an actively managed fund”, said the regulator.

That was the first time a European regulator has accused a bank of misselling a closet index fund, but the problem is not an isolated one.

An investigation by the Danish government found almost a third of Danish equity funds were in effect expensive clones of the index. In Sweden, a legal dispute has broken out between disgruntled fund investors and Swedbank Robur, the country’s biggest bank. The Swedish government is investigating the broader issue, and has called on other European governments to follow suit.

In the UK, more than a third of funds surveyed could be deemed index huggers, according to recent research carried out by fund management firm SCM Private.

Ireland appears to be little different, according to finance professor Martijn Cremers, co-author of a recent study entitled Indexing and Active Fund Management: International Evidence.

About a quarter of money invested in funds sold in Ireland is in closet index funds, according to the study. On average, these funds charge 2.48 per cent a year, almost identical to genuinely active funds and well above the 0.63 per cent charged by explicit index funds.

Investors concerned that their money may be invested in what is essentially nothing more than a clone of the index should enquire about their fund’s active share.

Percentage of portfolio

In a concept developed by Cremers and

Antti Petajisto

, active share refers to the percentage of the fund’s portfolio that differs from its benchmark. If a fund had an active share of 0, then it is identical to its benchmark index; if it has a score of 100, then the fund is completely different from the index. An active share of 60 or less is generally considered to be a closet index tracker.

Although active funds ostensibly aim to beat their benchmark index, it is extremely difficult to do so if they adopt a closet-indexing approach.

In a 2012 paper, Michael Malboussin of Legg Mason Capital Management gives the example of a fund with an annual management charge of 1.25 per cent and a low active share of 33 per cent.

As two-thirds of the portfolio is earning the same return as the benchmark index, the remaining active part has to deliver huge outperformance to justify the annual management fee.

To match the index after fees, the active portion needs to generate an extra 3.75 percentage points annually, Malboussin notes – a level of outperformance beyond even the most skilled of stock-pickers.

Unfortunately for investors, closet index funds have become increasingly common in recent decades. In 1980, according to Cremers and Petajisto, there were almost no funds with a low active share (defined as 20 to 60 per cent). By 2003, however, about 30 per cent of all assets were invested in closet trackers.

Similarly, the percentage of assets invested in funds with an active share of 80 per cent or more fell dramatically, from 58 per cent in 1980 to 28 per cent in 2003.

Petajisto refers to the Fidelity Magellan fund, made famous in the 1980s by the incredible returns achieved by superstar fund manager Peter Lynch, who was not afraid to take an aggressively contrarian approach until his 1990 retirement.

However, Fidelity took a decidedly more cautious approach as time passed, with its active share falling from 77 per cent in 1995 to 46 per cent in 1997 and to just 33 per cent in 2000.

During this time, money continued to flow into the fund from investors eager to enjoy market-beating returns, but the new quasi-indexing approach meant they were, inevitably, disappointed.

Although ordinary investors are hurt by closet indexing, their own behaviour has played a part in the growth of the practice. Even the best fund managers will go through periods of underperformance, often for multi-year periods.

In such circumstances, investors will often withdraw their money and the fund manager will be fired.

The problem of career risk means it makes sense for fund managers to play it safe, and ensure their own returns do not deviate too much from their benchmark. “Success is one thing,” as Lynch once quipped, “but it’s more important not to look bad if you fail.”

Disillusioned investors

While the number of closet index funds has mushroomed in recent decades, there is good reason to think that the practice may become less common in coming years. Recent years have seen a move away from active management in general, with disillusioned investors increasingly ploughing their money into cheap index funds.

Growing awareness regarding the issues of high fees and closet trackers means active funds will have to adopt the kind of transparent approach being pioneered by investors such as Britain's Neil Woodford. He has committed to publishing his fund's active share – in February, it stood at 81 per cent – as well as the exact equity holdings in his portfolio.

Other UK fund groups such as Threadneedle, Neptune and Bailie Gifford have followed suit and there are growing calls for publication of active share to become an industry norm.

An increased emphasis on funds’ active share stands to benefit skilled fund managers as well as ordinary investors. Money has flowed out of active funds and into passive funds over the last decade, with index fund proponents pointing out that their active brethren rarely deliver the goods – last year, 86 per cent of US managers underperformed their benchmark.

However, this figure is swollen by the huge number of unskilled closet indexers, who will inevitably underperform their benchmark.

In a paper last November, Simon Evans-Cook of Premier Multi-Asset Funds argues that funds that are 60 per cent passive should not be classed as active when their performance is judged. It is, he says, “like trying to calculate the average fuel efficiency of cars in the UK, but including lorries in your study”.

Current market cycle

Although UK closet trackers have underperformed over the current market cycle, highly active funds have actually outperformed by 2.9 per cent annually, he adds.

Petajisto’s work confirms this point. He found that between 1990 and 2009, funds with the highest active share beat their benchmarks by 1.26 per cent annually, after fees. Whilst closet index funds will typically contain hundreds of stocks, the best performing active funds contained an average of just 66 stocks.

Of course, such funds also run the risk of badly underperforming.

The concept of active share appears to be gaining currency among investors, with recent reports indicating fund managers are now being pressured by their marketing departments to increase their active share.

Assuming this trend continues, ordinary investors will be faced with a choice: should they invest in a concentrated fund with a high active share, one that may well convincingly beat the market but which also runs the risk of badly underperforming? Or should they opt for a cheap index fund?

It all depends on one’s risk appetite. Both options, however, are surely preferable to the no-man’s land of closet trackers.