Watch out for the closet tracker funds in your portfolio

published 25 November 2014

The UK fund management industry has a couple of shameful secrets. The first is the way it charges. I've written about this many times before so I won't bore you at length on the matter. I just want to send you in the direction of a new study from Cass Business School, which points out two things.

First is that the worst type of fee structure from the point of view of investors is one in which the manager is paid either a flat percentage of the assets under management, or a flat percentage plus a performance fee.

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On to the second shame: the huge number of index tracker funds in the UK masquerading as actively managed funds ("closet trackers"). This one might be worse. The fees business is exploitative, irritating and backward. The closet tracker business is all those things but with a hint of fraud chucked in. Why are they so awful? Simple. These are funds that are sold to you as being actively managed by some clever guy in the City and come with the kind of fees such clever guys think they deserve (the average ongoing charge is 1.43%).

However, they aren't actually particularly actively managed. Instead, their managers, hamstrung by their industry's terror of underperforming the index (what if people take their money out and they lose their job?) just buy and hold more or less the same stocks as are tracked by whatever their benchmark index is, and hope for the best. The result? Mediocre performance before fees are subtracted, and utterly awful performance after they are taken out.

But once you start to think about how many trackers there are in the UK that are classified as active by the industry another problem comes to light. Their existence skews the entire debate about the performance of the average active fund versus the average passive fund in the UK. Why? Because closet trackers (and their appalling performance) are classed as active funds. So when you compare the "average passive fund" to the "average active fund" you are actually comparing the passive sector to a combined group of lots of very expensive closet trackers and a smaller number of genuinely active funds. No wonder pure passive usually wins the numbers war.

The results are fascinating. Over the past ten years, the highly actives have returned an average of 10.3% a year (for those who aren't familiar with stock market return averages I would like to point out that this is amazing). The actives have returned 5.9% and low-cost trackers have returned 4.9%. The index has given you 4.8%. And closet trackers? You guessed it: 4.6%. Only the funds classified as high-cost trackers did worse.

Do the numbers this way and active management beats passive management hands down. Mr Evan-Cook isn't the only one to come up with these results. The original Yale report found something almost identical. Its conclusion: "Funds with the highest Active Share significantly outperformed their benchmarks", both before and after expenses, and they "exhibited strong performance persistence". Other studies have shown that small or "best ideas" portfolios run by managers with real conviction have a tendency to outperform other funds too.

So what does this tell us? The first part of that answer is not everything. There's what we call "survivor bias" in the numbers. Fund managers whose convictions have turned out to be completely wrong will have been shut down: failure isn't properly recorded. Then there is the fact that you should never judge investments on one measure alone. A fund with, say, only three stocks in it would have a very high active share. But it would also be running whopping levels of risk. You wouldn't want it in your pension.

These caveats aside, I think it tells us that we should start agitating for AS to be included on the fact sheet of all the funds on the market so that we can see whether our manager is a person of conviction or not. If we are paying for active we must make sure we get active! This is something that the fund platforms might like to have a go at providing all those analysts at Hargreaves Lansdown should be able to knock out the AS numbers for the funds on their site in a couple of days.

It also tells us that if we are going to buy passive funds we must buy cheap and transparent passive funds. Obvious but important. And finally it tells us that the statistical battle between active and passive managers is not yet won: if you are looking for long-term outperformance (and who isn't?) there is, after all, a very good case to be made for buying funds with very high AS, a good record and a reasonable price. Next week: a list of candidates (suggestions, as ever, very welcome).

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast - but still writes for Moneyweek monthly.

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.