Outing closet tracker funds with smart beta

One of the most outrageous scams in the financial industry (and that's saying something) is about to be challenged in court: 2,500 investors have signed up to a class action initiated by the Swedish Shareholders' Association, claiming they were mis-sold funds.

The funds they bought were labelled "active", suggesting that they would come with a high fee, but be run by clever people working hard to choose the best stocks and outperform a relevant index. Instead, they say, they got funds that, as the Financial Times puts it, "did little more than hug the index".

We've written a great deal in MoneyWeek over the years about how angry "closet trackers" make us. Selling them to investors is clearly a nasty type of wealth thievery and it also plays its part in dragging down the reputation of the fund-management business as a whole. We look forward to seeing a similar class action in London.

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In the meantime, I'm pleased to say that the industry is having a go at creating some better products. Last week came news of a fund that will charge only performance fees. The fees structure doesn't quite work for me (see my blog on this), but if you don't get paid unless your return deviates properly from the index, there is at least little chance of you turning your fund into a closet tracker.

That's good. But another of the new offerings might be better. It is a 'smart beta' exchange-traded fund (ETF). Regular readers will know that I'm a fan of these. Fund management is in theory not particularly complicated. If you pick a proven strategy and stick to it, you should do just fine. Unfortunately, most managers can't stick to a strategy. Instead, they make exceptions to their own rules at every turn: they fiddle, fudge and fuss their way to failure. Smart-beta funds can't do this: a human chooses the strategy and they automatically follow it.

This one stands out because it uses the work of and has the endorsement of Professor Robert Shiller, the inventor of the cyclically adjusted p/e ratio (or Cape), our favourite valuation measure. Fund-management firm Ossiam has taken the idea of Cape and tested it to see if it can be a predictor of the performance of different sectors in Europe. They believe it can.

So the Ossiam Shiller Barclays Cape Europe Sector Value ETF looks for the five cheapest sectors, chucks out those with the worst price momentum, and keeps the rest. The result is a neat mix of momentum and value strategies. We like both of those. One to keep an eye on.

I met Shiller this week and asked him if the strategy might work for countries, and if so, if he would be prepared to buy a basket of the four lowest Cape countries on his lists Russia, Greece, Portugal and Italy. He wouldn't be. He would, on the other hand, buy Italy and "the next ones up". John Stepek reckons that's a good call see his cover story.