Behind the Numbers: How bad is the closet tracker problem?

Moeller-Jake

It’s a tough time to be an active fund manager. Arguably it has been difficult since the height of the global financial crisis when active funds’ fallibilities were revealed in that traumatic “correlation one” event.

Since then, scrutiny by investors and regulators has been unrelenting, which 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 that 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 2012-2014 to seek out closet indexers. It concluded that “between 5 and 15 per cent of Ucits funds” could be closet trackers, leading to much industry comment.

Such clamour is understandable. Closet indexing refers to funds that are ostensibly actively managed, and charge active management fees, but that in reality do not take significant active positions. That is, they hug the composition of their nominated index, much like a passive tracker fund.

The issue revolves around misrepresentation. Where a client pays for funds to be actively managed but the fund managers in all probability haven’t justified their fee and possibly the client has been misled. Genuinely active fund houses do not wish to be associated with any claims that they are being lazy in their fund selection.

As a passionate advocate of the benefits of active fund management and a former multi manager, I can relate to the concern of passive funds masquerading as active ones and skimming off more fees than they deserve.

“It might be hard for investors to hear, but most active fund houses want to do the right thing.”

However, there appears to be a growing level of hyperbole on this issue that implies this is some sort of trick active fund houses keep up their sleeve to further fleece the 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 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 fund managers to park themselves in an index position when they lack any clear conviction on the markets.

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What of the “core” fund? Is it an active fund strategy that has broad-based exposure across its index, taking a lot of small individual tilts? Let there be no doubt, investing in active funds requires considerably more ongoing due diligence than investing in passive ones. Any investors in active funds, and the advisers who put them there, should have at least performed some cursory research as to the pedigree of that house and fund manager.

Investment houses are sharing more information on their funds than ever before, and most now prudently manage fund sizes to prevent the funds from tending toward index positions. Active share, the percentage of stock holdings differing from the benchmark, is by no means a new concept, but it has become an increasingly popular measure to show fund managers’ proximity or otherwise to their benchmark.

It does require, however, a lot of work to obtain 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. It is a returns-based metric to use readily as a proxy for “activeness”.

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 January 2016, 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 tracking error score similar to an average of index funds.

IA UK All Companies sector

There are 33 index funds in this sector with more than five years of performance. The average of their tracking error  scores stands at 0.77 per cent. Of the entire 233 funds within the IA UK All Companies classification in this analysis, only six that are marked as being active have a tracking error  score lower than the passive average, which is 2.6 per cent of the sector.

IA North America sector

There are eight index funds in this sector with more than five years of performance. The average of their tracking error scores stands at 0.65 per cent. Of the 85 funds within the IA North America sector, three marked as active return a tracking error score lower than this, or 3.5 per cent of the sector.

IA Europe ex-UK sector

There are eight index funds in this sector with more than five years of performance. The average of their tracking error scores stands at 0.94 per cent. Of the 89 funds in the IA Europe Excluding UK sector only two funds marked as active return a tracking error score lower than this, which is 2.2 per cent of the sector.

IA Asia Pacific ex-Japan sector

There are seven index funds in this sector with more than five years of performance. The average of their tracking error scores stands at 0.44 per cent. Of the 56 funds in the sector none marked as active have a tracking error score lower than this.

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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 reassurance that the problem may not be as bad as perceived, with the findings considerably lower than the 5 per cent to 15 per cent Esma has cited.

There are certainly some problems. 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 adapting in the face of better informed investors who are willing to exert their consumer sovereignty.

It might be hard for investors to hear, but most active fund houses want to do the right thing. There is so much fund scrutiny by fund selectors, asset consultants, gatekeepers and the financial media that any fund misrepresenting itself would quickly find itself off the buy lists.

The numbers

5-15% Number of Ucits funds that are closet trackers, according to Esma

Funds in the North America sector that are potential closet trackers

2014 Period Esma carried out its research on closet trackers

Funds in the UK All Companies sector that are potential closet trackers

3.24 Tracking error of Legg Mason Opportunities fund

Jake Moeller is head of UK & Ireland research at Thomson Reuters Lipper