Worried you might own a closet tracker fund? Time to get to know your portfolio better

Last week, the City watchdog – the Financial Conduct Authority (FCA) – released its latest review of the fund management sector.

The FCA wanted to look at whether the asset management industry provides value for money for investors. The short answer was “no”.

Prices are oddly sticky (the charges on active funds haven’t changed much over the years), and profit margins are consistently high, suggesting that competition in the market isn’t doing much for consumers. So the regulator has suggested a number of “remedies” to fix this.

But there’s one issue that drew surprisingly little attention: the rip-off that is “closet tracker” funds…

How one in ten fund investors could be getting ripped off by the City 

Here’s a throwaway line from the Financial Conduct Authority’s review of the asset management industry, released last week.

“We find that many active funds offer similar exposure to passive funds, but some charge significantly more for this. We estimate that there is around £109bn in ‘active’ funds that closely mirror the market, which are significantly more expensive than passive funds.”

This is what’s known as a closet tracker. If £109bn is sitting in closet trackers, that equates to about a tenth of the money being managed for “retail” investors (that’s individuals like me and you) in the UK. This is a bad thing.

Tracker funds offer nothing more than the promise to mirror the underlying index as closely as possible. Because they don’t do anything clever, they don’t charge much for doing it. So a passive fund might cost you 0.1% a year, versus 1% or more for an active fund. It’s also notable that passive funds have consistently fallen in price in recent years, whereas active fund fees have remained pretty stable.

A closet tracker, on the other hand, basically tracks the market (like a passive fund) but charges you a much higher fee for doing so (like an active fund). So you get passive performance and pay active fees.

Clearly, this is outrageous. If you pay for an active fund, then you should get active investing. To be very clear, that doesn’t mean the fund you choose will beat the market. In fact, judging by history, it’s more likely that your manager will fail to beat the market, possibly quite substantially.

However, you do expect them to at least try.

What makes an active fund active?

So what is active investing? More than anything else, it involves doing something different to the wider market. As well-known US distressed debt investor Howard Marks of Oakfield Capital puts it: “You can’t take the same actions as everyone else and expect to outperform… being different is absolutely essential if you want a chance at being superior.”

It’s hard to be different. For a start, just because you’re different, doesn’t mean you’ll do better than the market. Markets aren’t efficient in the way that the efficient market hypothesis suggests they are – they aren’t perfect, and there are plenty of inefficiencies and little glitches that make it possible to beat the market.

But outwith the extremes, markets do tend to be reasonably good at pricing things, and finding an edge which enables you to do better than everyone else is not at all easy.

Moreover, it’s also hard to be different because both individual and organisational psychology militate against going against our peers. As individuals, we like to feel part of the herd. It’s safer to be part of the tribe than to be an outsider. And as a cog in a large organisation, the rewards of being right and different are often far outweighed by the risks of being wrong and different.

If you make an out-of-consensus call, and you get it right when everyone else is wrong, then for every person who respects you, there will be three who resent you. And if you make a contrarian call and get it wrong, you’ll be first to get the chop in any future staff cull (especially if you’ve already built up a record of resentment from prior correct calls).

In short, for many fund managers – particularly those who work for mainstream institutions – there’s no real incentive to be radically different from their peers. There’s a good chance they’ll get it wrong, and if they get it right, the rewards just aren’t that great.

So you can see why active managers might want to play it safe and just hug the index. But in that case, they also need to take a big pay cut.

If you think you might own a closet tracker, you need to do some homework

So what can you do about this? There are certain measures you can look at to test if a fund is a closet tracker – the “active share” of a fund (if you can find it), or how closely it hugs the benchmark.

But if you’re at all worried that you own a closet tracker fund, then it points to some more fundamental issues with your portfolio. Because if you do own a closet tracker, you have to wonder how it ended up in there in the first place. It suggests strongly that your knowledge and understanding of your own investments is lacking.

So make sure you know what you are investing in. What funds are in your pension or individual savings account? How much do these funds charge? And why do you own them in the first place?

If you’re struggling to answer those questions, then you need to make a list. Get the name of the funds. Get the ongoing charge figure (OCF). Write down what the fund aims to do.

For each active fund, write down why you own it, rather than a passive equivalent. So if you own a UK equity fund, why is it a better option than a FTSE 350 tracker? What is the fund manager’s plan for beating the market, and does he or she stick to it? If you can’t work out what it is that makes the fund different, and cannot articulate a decent reason for owning it rather than a passive option, then you need to think about selling – or at least asking your financial adviser (assuming you have one) some hard questions.

Don’t wait for the regulator to act for you. Managing your money doesn’t need to involve a lot of work, and it’s absolutely fine to use an advisor to help you get things in order. But ultimately, this is your money. If you don’t at least know what it’s invested in and why, then you are leaving yourself wide open to being taken advantage of.