Outing the closet index funds

If you own a Volkswagen you probably know you can buy a similar car under the Skoda logo for less say, 10% for an equivalent with both running on the same engine. But you might still stick with the old brand. Now imagine that the VW was not 10%, but 1,000% more expensive. Surely anyone in their right mind would choose the Skoda?

Yet, according to new research from fund manager SCM Private, many of us ignore a huge cost gap when choosing active funds over indexed equivalents, even though there's little difference between them. SCM reports that nearly half of the average actively managed UK equity fund is closet indexed. In other words, many fund managers largely replicate their benchmark index, while charging investors an arm and a leg for a service they could get far more cheaply elsewhere.

As a reminder, the average actively managed UK equity fund costs around 1.5%-1.75% a year. You can buy a FTSE All-Share index tracker from firms such as SWIP or Vanguard for a tenth or less of that annual cost. Yet only a quarter of UK equity funds have holdings that radically differ from those of the index, SCM reports. These truly active funds have also performed much better than the closet indexers. However, there's no guarantee that even the fund managers who do stick their necks out will continue to prosper.

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SCM's founder, Alan Miller (once a leading stock picker before turning his interest to index funds and exchange-traded funds), tells me that the recent outperformance of some more concentrated active funds was due to their heavy holdings in small- and mid-caps, which have done well. Whether or not that trend continues, at least that subset of truly active managers was doing what it was paid for. By contrast, the managers of the closet indexed' funds may well, in SCM's view, be in breach of the Financial Conduct Authority's regulatory guideline to "conduct business with integrity".

The implications for investors are clear. Use a cheap index fund for core holdings in the stock market. If you want to use an active fund manager, at least choose one who is prepared to have a view.

Alternatively, for your non-core' equity holdings, you can either buy individual stocks or one of the new generation of smart beta' funds, which follow an active strategy, but do so at a much lower cost than the typical fund manager.

Paul Amery is a freelance journalist, formerly a fund manager and trader.