The asset management industry has been square in the crosshairs of regulators, both here and abroad, for some time now. Now that the FCA’s final comprehensive industry review has landed, it looks like the industry will be in store for a substantial shakeup.
But while the headlines are rightly focused on the big-ticket items – systemic underperformance, fee clustering, fund governance and so on – there has been less attention paid to another troublesome industry trend, highlighted in its earlier interim report, namely closet trackers.
These are funds with a low ‘active share ratio’, which essentially measures the degree to which portfolios deviate from the benchmark (from 1 to 100) – basically a snapshot of the extent to which a manager is trying to beat (or simply do something different from) the wider market. ESMA and the FCA have been both been very critical of this all-too-common practise of investors paying ‘active prices’, where they would get better returns by simply switching to an equivalent tracker.
Much of the discussion around active share ratio focuses on the lower end – with the main focus being closet trackers that barely move from the underlying index. These are defined by ESMA as funds with an active share ratio of 60 or less. Risk-comfortable investors who want superior returns and are looking to beat the market should always steer clear of these as a general rule – you won’t get your money’s worth.
But does that mean risk-comfortable investors should go the other way and always look for funds with the highest active share ratios?
Not necessarily. It should definitely be a consideration to an extent. A counter-cyclical approach (the best way to drive outperformance in the long run) will automatically and by definition mean moving away from the benchmark a lot of the time (e.g. buying unfavoured stocks, or taking profits during bull runs). Despite ‘buy low, sell high’ being recognised as investment 101, it is astonishing how many do the precise opposite – it’s partly thanks to this that the best managers are able to do as well as they do. So broadly speaking investors should expect a fund manager worth their time to be posting reasonably consistently high active share ratios.
However, at the other extreme, it’s unlikely that a 100 per cent for-the-sake-of-it contrarian approach (the only way to get a ratio of 100) will prove the best strategy. A lot of fund managers with persistently high active share ratios aren’t intentionally aiming to keep their active share ratio high per se – their high ratios simply reflect the fact that their funds are pursuing a different strategy to the crowd. What this strategy is, and the extent to which the manager can deliver on its objectives (and has done in the past), remains a crucial consideration
Nevertheless, sophisticated investors that are looking for outperformance should generally be selecting from funds within the higher range of active share ratios.