Jake Moeller examines recent discussions in the closet trackers debate.
It’s a tough time to be an active fund manager. Arguably it has been since the height of the global financial crisis when their fallibility was revealed in that traumatic event. Since then scrutiny by investors, regulators and financial media has been unrelenting and it has had a material impact on how active fund managers run their business. Reforms on the disclosures of fees are well documented, examination of inducements has affected how fund managers and gatekeepers interact and, the increasing prevalence of passive instruments and “robo” distribution has exerted more margin pressures on fund groups than ever before.
More recently – it is the closet tracker problem which is garnering considerable headlines. In early February 2016 the European Securities and Markets Authority (ESMA) published a statement referring to sampling it had undertaken during 2012-14 to seek out closet indexers. It concluded that “between 5-15% of Ucits funds” could be closet trackers. A recent editorial in Investment Week called this a “serious blight on the whole active management fund industry” and made a passionate call for fund groups to “act now” to reform this issue. The Chief Executive Officer of Hermes Investment Management, Saker Nusseibeh was quoted in Ignites Europe as saying the level of closet tracking in the industry is “disturbing.”
What is closet tracking?
Such clamour is understandable. Closet tracking or indexing refers to funds which are ostensibly actively managed – and charge active management fees, but in reality, do not take significant active positions. That is they hug the composition of their nominated index – much like a cheaper tracker fund. This issue revolves around misrepresentation. Where a client pays for a fund to be actively managed but the fund doesn’t really take materially active positions, the fund manager in all probability hasn’t justified their fee and possibly, the client has been misled.
As a passionate advocate of the benefits of active funds management and a former multi-manager, I can relate to the concerns of passive funds masquerading as active ones and skimming off more fees than they deserve. However, there appears to be a growing level of hyperbole on this issue that implies that this is some sort of trick active fund houses keep up their sleeve in order to further fleece an unwary investing public.
This is a very sceptical view indeed. In my entire career I have sold an active fund on only a single occasion because I believed that it was entrenched in an index position. And this is part of the problem of having a regulator trying to legislate on this issue. What defines a closet tracker? What period of time constitutes an offence? It is a perfectly legitimate strategy for a fund manager to park themselves in an index position when they lack any clear conviction on the markets. What of the “core” fund? –an active fund strategy which has broad based exposure across its index – taking a lot of small individual tilts. Such funds may have a low tracking error, but can still out-perform an index.
Active funds and due diligence
What of caveat emptor? Be there no doubt – investing in active funds can provide an investor with the chance of beating a tracker fund but they can also under-perform and require considerably more on-going due diligence than a passive investment. Any investor in an active fund (and/or the advisor who put them there), should have at least undertaken some cursory research as to the pedigree of that house and fund manager, and should review their funds regularly.
Fortunately today, investment houses are more transparent than ever with information on their product suites available directly from their websites. Also, there are many fund ratings provided by data vendors such as the Lipper Leaders scores which pick up under-performance and qualitative fund reports (such as my Fund Manager Briefing series) which are freely available on-line. Furthermore, many fund houses now prudently manage fund sizes to prevent managers from having to invest in too many securities – often a key reason for veering towards index positions.
How can we identify the closet trackers?
Active share – the percentage of stock holdings differing from the benchmark – is by no means a new concept but it has become increasingly popular measure to show fund managers’ proximity or otherwise to their benchmark. It does require however, a lot of work in obtaining current and historical portfolio information, much of which is often confidential. Tracking error (standard deviation of excess returns from a benchmark) is also popular and appears in the oft quoted Information Ratio. Tracking error is a readily usable returns-based metric to use as a proxy to measure how far fund managers are deviating from the composition of the benchmark they follow.
It is relatively straightforward in Lipper for Investment Management to create a screen which compares how active all funds in any classification scheme are. By taking the 12 month tracking error against the stated benchmarks provided by a fund manager and looking at it over monthly rolling periods for the five years ended 31 Jan 2016 (we can call the average of these rolling observations the “tracking error or TE score”), it is possible to get a picture of how active a fund has been against its benchmark and within its peer group. A closet tracker should exhibit a TE score similar to the average returned by those of index funds.
Results from popular Investment Association classifications
There are 33 index funds in this sector with more than five years of performance. The average of their TE scores stands at 0.77%. Of the entire 233 funds within the IA UK All Companies classification in this analysis (funds where a benchmark has been stated by the fund manager), only six funds that are marked as being active return a TE score lower than the passive average (2.6% of the sector).
There are eight index funds in this sector with more than five years of performance. The average of their TE scores stands at 0.94%. Of the entire 89 funds within the IA Europe excluding UK classification in this analysis (funds where a benchmark has been stated by the fund manager), only two funds marked as active return a TE score lower than this (2.2% of the sector).
Table 1. Funds ranked by TE score in IA UK All Companies and Europe ex UK classifications (as at January 31, 2016)
There are eight index funds in this sector with more than five years of performance. The average of their TE scores stands at 0.65%. Of the entire 85 funds within the IA North America classification in this analysis (funds where a benchmark has been stated by the fund manager), only three funds marked as active return a TE score lower than this (3.5% of the sector).
There are seven index funds in this sector with more than five years of performance. The average of their TE scores stands at 0.44%. Of the entire 56 funds within the IA Asia ex Japan classification in this analysis (funds where a benchmark has been stated by the fund manager), not a single fund marked as active returns a TE score lower than this (0.0% of the sector).
Table 2. Funds ranked by TE score in IA North America and Asia Pacific ex-Japan classifications (as at January 31, 2016)
Similar analysis can be undertaken for fixed income and mixed asset funds, but there is a lack of asset homogeneity and asset allocation decisions that makes this a more arduous task. Generally, the accusation of closet tracking is more prevalent in funds within the homogenous equity sectors. The analysis considered above although high level, should provide some evidence that the problem may not be as bad as is perceived and the findings here are considerably lower than the 5-15% ESMA has cited.
There are certainly problems. Some banks and insurance companies, many of which have had the benefit of tied distribution, have grown some large and comparatively unwieldy mandates. However, they are vehicles of another age with many of them actually built with low tracking error and turnover parameters. They lack the nimbleness to compete against more dynamic competitors and many are being forced to adapt in the face of better informed investors willing to exert their consumer sovereignty. Bad publicity for large institutions with such retail facing mandates is forcing them to update and refresh their investment propositions.
It might be hard for regulators and sceptical investors to swallow, but most active fund houses want to do the right thing. Most active fund managers genuinely align their fortunes with those of their investors and have well resourced compliance teams to warn if risk budgets are not being used. Reputable active fund houses do not wish to be associated with any claims that they are being lazy in their stock selection.
Today, there is so much scrutiny by fund selectors, asset consultants, gatekeepers and the financial media that any fund misrepresenting itself as an active proposition would quickly find itself off the buy lists and fund platforms which form the lion’s share of their retail business.
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