The choice between active and passive fund management has been widely debated. Active funds purport the chance to outperform the market, at a higher price and greater risk, while passive funds usually offer average market performance but at a much lower cost and risk. Passive funds offer the benefit of paying less in management fees, which often boosts the overall returns above the performance of typical active funds. In an interview last month with FT Adviser Peter Westaway, Vanguard’s Chief Economist for Europe wisely said: “There is only one element of your total return that you can know in advance and that is cost”. At Quadrant, we agree that cost should be a really big consideration (and you can read my blogs on the subject, for example ‘Why 1% Matters‘).
The investment industry is often presented as two opposing camps – active and passive. But there is a third group. Some investors may think they are investing with active managers but these funds are actually ‘closet’ indexers. They are hugging the market benchmark but are charging more than passive trackers. A recent report by SCM Direct on closet indexation reveals that more than a third of UK funds (36%) are no more than expensive copies of index (passive) funds. It states:
“The problem is that closet indexers are very expensive relative to what they offer. A closet indexer charges active management fees on all the assets in the mutual fund, even when some of the assets are simply invested in the benchmark index. If a fund has an Active Share of 33%, this means that fund-level annual expenses of 1.5% amount to 4.5% as a fraction of the active positions of the fund. Since only the active positions of the fund can possibly outperform the benchmark, in the long run it is very difficult for a closet indexer to overcome such fees and beat its index net of all expenses.”
This group is impossible to justify, doomed to underperform and misguided by the business rationale that by tracking the index they will never be at the bottom of the league tables. It is safer to generally track indices rather than take on the greater risks of a more active approach. However, as the old idiom goes: “You can’t have your cake and eat it too.” SCM direct found that rolled-out across the industry based on the 10 worst offending UK funds, this wide spread deceptive practice of closet indexation could have cost investors £803m in 2014. Shockingly, the report found that every single one of the 10 funds with the lowest active share analysed (i.e. greatest degree of closet indexation) underperformed the market by an average of 2.8%.
How to Spot A Closet Fund
Unsurprisingly, closet trackers do not advertise themselves as such, so how do you spot them? There is a measure called Active Share. Research presented in 2006 by Martijn Cremers and Antti Petajisto of the Yale School of Management introduced the term, which is the percentage of stock holdings in a portfolio that differ from the benchmark index. Crudely explained, at one end of the spectrum an Active Share value of zero is a purely passive fund and an active share of 100% would be one that is just held in a single stock. Examining 2,650 funds from 1980 to 2003, Cremers and Petajisto found that that funds were trending toward low Active Share. The study states that the percentage of assets under management with Active Share of less than 60% increased from 1.5% in 1980 to 40.7% in 2003. Correspondingly, the percentage of fund assets with Active Share greater than 80% went down, from 58% in 1980 to 28% in 2003.
So, why doesn’t the Financial Conduct Authority require active funds to disclose their Active Share?
The UK’s Financial Services Consumer Panel (FSCP), an influential body that advises the FCA on consumer protection, said in its 2014 report on investment costs and charges that “Frequent monitoring of short-term performance combined with inadequate scrutiny of costs encourages the practice of ‘closet indexation’, also known as ‘closet tracking’: funds that charge for active portfolio management, typically of company stocks, but which in practice do little more than mimic the composition of a relevant index… To help consumers and their representatives assess value for money, the regulator could usefully consider a requirement for fund managers to justify that their management of index constituents was active management, rather than closet index tracking. This would probably require trading disclosure for active managers, that is, to disclose what proportion of their trading was on index constituents.”
It is astonishing that the FCA do not appear to be taking steps to implement the FSCP recommendations that active managers should disclose their Active Share. Without doubt, closet indexation is fraudulent and should be addressed as a matter of urgency. It clearly breaches the FCA’s over-riding principle 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”. In contrast, European regulators are taking this issue seriously with class-actions against fund groups now starting.
SCM believes so strongly that the only way to protect UK investors and curtail closet indexing is for a class action to take place in the UK that they are prepared to offer their services as expert witnesses, on a pro bono basis, to any investors wanting to commence such an action against any of the large UK fund managers.
Opinions on active vs. passive management will continue to be divided. I’ve said plenty before on that subject and I won’t repeat myself here. But one thing that both sides can agree on is that closet indexers don’t help the industry.
This article does not constitute financial advice. Individuals must not rely on this information to make a financial or investment decision. Before making any decision, we recommend you consult your financial planner to take into account your particular investment objectives, financial situation and individual needs. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections.