The UK’s investing public has changed. Years of headlines critiquing ‘closet trackers’ for charging full-fat, active-management prices while simply tracking a stockmarket index have taken their toll. And now, the focus on closet-tracker overcharging appears to have reached fever pitch.
In a recent column in Fund Strategy, star fund manager Neil Woodford said today’s investors are choosing between cheap access to markets through passive investing, or paying more for highly active funds that offer the potential for a better return.
“Two valid options, but the bulk of the fund management industry sits awkwardly in the middle of this spectrum. I believe this part of the industry is, at last, coming under threat,” he said.
So just how deeply is the trend changing the fund industry’s portfolio construction and marketing approach?
For many years the managers of large investment funds, especially in the institutional world, often described their portfolios as ‘benchmark constrained’.
They were permitted to deviate by just one or two percentage points from the benchmark weighting for any of their index’s shares.
But benchmark constraints became unpopular. They were seen as serving to help investment managers minimise the risk of underperforming rather than serving clients.
It was felt the funds’ fees, which in the retail world would often be 1.5 per cent a year thanks to bundled distribution and advice costs, would always wipe out any positive outperformance of the index.
The birth of ‘benchmark aware’
In the Nineties the rise of star fund managers like Neil Woodford, who made waves by taking large active sector bets against the index, encouraged marketers to promote retail funds with a little more oomph.
The buzz phrase became ‘benchmark aware, not benchmark constrained’, and that is where many major funds remain today.
Take one of the largest funds in the IA UK All Companies sector – the £2bn Threadneedle UK fund. It shares six stocks in common with its benchmark index, the FTSE All-Share.
But although its top 10 holdings look similar to its benchmark, there is active positioning at play.
The fund’s seventh-place holding in insurance group Legal & General, for example, is a major active bet; in the benchmark, L&G ranks in 35th place.
In fact, even though the fund has Royal Dutch Shell as its second-largest holding, its weighting of 3.7 per cent towards the oil giant is significantly underweight the index’s 7.5 per cent weighting.
The fund is so underweight Shell that its presence in the fund may reflect nothing more than a desire to show a degree of ‘awareness’ of the benchmark index.
Coming out of the closet
The lean years of low interest rates and low capital market returns since the 2008 financial crisis, combined with rising interest in transparency and responsible capitalism, have changed the public mood in recent months.
Today, even benchmark aware funds that take large, active bets against the stockmarket are being looked at with a cynical eye.
“Benchmark aware is being polite,” says James Budden, director of retail marketing and distribution at Baillie Gifford. “If you want that then buy a tracker.”
He says many benchmark-aware funds are in fact “pseudo active”, and should be avoided in favour of fully unconstrained funds.
“These funds closet track but charge active-type fees,” he adds.
“In the end people will realise that they are being diddled and will vote with their feet. This is a good thing for those active managers among us who are providing a truly active service.”
Last April, the FCA published a thematic review examining 23 funds and four segregated mandates from 19 asset managers, claiming seven had not provided a clear description of how they were being managed.
The FCA said three of the funds had been found to be operating old-style, benchmark constrained approaches without even telling their investors.
The regulator put fund managers on notice to up their game on disclosure, and warned distributors to consider their duty to find value for money for their end investors.
Elsewhere, Morningstar published a high profile study last March suggesting 20 per cent of Europe-based funds fit the criteria of being “closet trackers”.
Weeding out the benchmark-huggers
One of the problems investors and their advisers face is that it can be difficult to identify closet trackers.
In new research compiled by Morningstar for Fund Strategy, funds that are flagged with potential indicators for trackers are shown.
The funds are ranked by their “R-Squared”, a measure of how much they have in common with key benchmark indices.
The figures highlight 13 funds in Morningstar’s US Large-Cap Blend Equity sector with a high R-Squared above 90 per cent.
The effects of high index commonality can be observed in the fact that tracking error – deviation from benchmark performance – drops as the R-Squared figure rises.
The funds charge investors at least 0.8 per cent a year, with an average charge of 1.2 per cent a year. Critics would argue the funds are struggling to justify these fees.
But the figures are only indicative. Other measures of closet trackers such as active share are similarly shallow, and can give false positives and negatives. This has helped to create a general sense of suspicion about the fund industry.
One of the most conspicuous results of the focus on activity and charges is the rise of passive investing, with dozens of ultra low cost passive funds today offering investors simple, cheap access to diverse global markets.
The trend is being driven by research – and accompanying press headlines – showing controlling costs is vital to ensure long-term success from investing.
According to an academic review by US firm Hotchkis & Wiley in 2015, the prevailing consensus is that the average active fund manager tends to underperform after fees, although some active managers have demonstrated the ability to outperform.
Sales data from fund trade body the Investment Association shows UK investors are buying low-cost passive funds in droves.
The proportion of UK industry money held in passive open-ended funds rose to 13.5 per cent by the end of last year, compared to 11.3 per cent a year before.
The figures do not even include exchange-traded funds, another rapidly growing form of passive investing.
Passive investing now has such a head of steam behind it that some advisers and wealth managers buy only passive funds for their clients.
According to Bank of America Merrill Lynch analysis, in the US 30 per cent of the retail market is now invested through passive strategies.
With the focus increasing on passive investing in the UK, the evidence suggests passive is going to continue to snap up market share on this side of the pond.
Passive investing has passionate advocates, and many now believe the bulk of a portfolio should be invested simply by tracking markets at a low cost.
But some have voiced concerns. Goldman Sachs’ high profile investment manager Tim O’Neill has said that if passive investing becomes too big a part of a stockmarket, the prices of individual stocks will cease to move based on the quality of the companies they represent.
This, he has said, makes passive investing a potential “bubble machine”.
Rob Burdett, co-head of multi-manager at BMO Global Asset Management, says passive investing may be a gravy train.
“We see the huge increase in flows to passives as in part being due to strong marketing, using historic ‘facts’ of indices beating peer group averages in recent times,” he says.
“Conversely, the active sector in effect deals in hope, offering the prospect of potential out-performance without any guarantees.
“To the gifted marketer the former is a lot easier to work with but it does not mean the same as investors getting the right outcome.”
He adds that because financial intermediaries levy fees on their clients, those advisers that only employ passive investments run the risk of guaranteeing poor outcomes in the long run.
Conversely those who select highly active funds at least have the chance of their clients’ portfolios outperforming by enough to cover the advice fee, he says.
The courage of one’s convictions
According to the Hotchkis & Wiley study, it was also found that high conviction was a common characteristic in outperforming fund managers.
Several studies in the US have suggested funds with a high active share, indicating divergence from their benchmark index, are more likely to outperform. Other studies have suggested that low active share can be a predictor of poor performance.
The evidence has clearly been enough to convince many fund buyers. The latest data on individual fund sales shows highly active players are being bought in high volumes.
Combining sales figures from Fidelity and The Share Centre with FE Analytics data shows that almost all top-selling funds in recent months report R-Squared figures of less than 90 per cent.
Some of the best-selling funds are managed by Woodford, whose new fund house has insufficient track record to show R-Squared and tracking error comparisons with the other funds listed.
However, Woodford is known to be one of the most active fund managers operating in the UK today, adopting portfolios of high conviction shares. This might help to explain the funds’ dizzying rankings in the sales statistics.
The average R-Squared for funds on both lists is 68 per cent, while their tracking error was on average 7 per cent in the past three years, suggesting high levels of benchmark divergence.
The industry seems to have recognised the trend towards high conviction ‘unconstrained’ investing, and its marketing efforts are evolving to match.
Laith Khalaf of fund broking giant Hargreaves Lansdown says the firm has been aware of the trend towards passive and highly active funds for some time.
“Funds in the middle [are] being slowly squeezed out of the picture,” he says.
“This is happening as a result of a number of concomitant factors: the passive price war, increasing investor engagement and a focus on getting value for money.”
He says the group’s Wealth 150 ‘buy list’ of recommended funds is entirely comprised of funds with the potential to deliver outperformance, rather than hugging a benchmark, and now includes passive funds.
“I do think the trend has much further to run because there is still a huge amount of money held in lacklustre funds charging over the odds, and this shift is a force for good because ultimately it will mean more money flowing through to investors from better fund performance and lower costs,” he adds.
Baillie Gifford’s Budden says he doubts the trend has taken off in earnest.
“What we are seeing is an unveiling of closet tracking, not a move to unconstrained investing,” he says.
But he says any move towards transparency and away from closet tracking is welcome.
“This is a good thing for consumers as they might actually get value for money. They deserve better transparency around what makes a genuinely active manager,” he says.
BMO Global Asset Management’s Burdett says the trend towards unconstrained investing will be good in general, but “the devil will be in the detail”.
“As with any fund it depends on the manager being appropriate for such a mandate and there is a danger the marketing departments latch onto the trend but the fund managers told to run such funds can’t deliver,” he says. “Fund selectors should find managers who want to run such active funds and have the apparent skills and environment around them to do so, and ideally proven ability too.”
High conviction heroes
So for buyers looking for unconstrained funds, which are the most active UK large-cap equity products on the market?
The £184m Ardevora UK Equity fund sits at the top of our top 20 list of funds in Morningstar’s UK Large-Cap Blend Equity sector with the lowest R-Squared values.
Managed by Jeremy Lang and William Pattisson, the fund’s R-Squared may be flattered by its use of gearing to create a ratio of long bets (that shares will rise) to short bets (that shares will fall) of 150:50.
The figures may also benefit from the fund’s unusual use of the MSCI UK Investable Market index.
However the fund gained 119.2 per cent from its launch in February 2011 to date, compared with an average return in the IA UK All Companies sector of 63.1 per cent, suggesting it is far from a tracker.
In second place the £47m RWC UK Focus Fund run by John Innes has gained 81 per cent since launch in December 2010 versus a FTSE All-Share return of 63.1 per cent, adding further weight to the theory that high conviction means higher returns.
As arguably the most unconstrained funds operating in the UK equity universe, our list could represent some of the future winners of the asset management industry. With the trend towards investing in either high conviction or passive funds looking likely to grow, the UK fund industry’s ‘bloated middle’ of benchmark-aware funds look set to be squeezed.
119.2% Return since launch on the Ardevora UK Equity fund, which has the lowest R-Squared value
20% Number of Europe-based funds classed as ‘closet trackers’ by Morningstar
13 Funds in Morningstar’s US Large-Cap Blend Equity sector with R-Squared value above 90%