The days of this sneaky financial market rip-off are numbered

One of the biggest debates in investing is over active' vs passive' investing.

It boils down to this: should you pay a fund manager to pick and choose stocks, in the hope of beating the market? Or should you go for the cheaper option, and just opt to match the market's performance?

There are arguments for both. Some active managers and strategies can actually beat the market regularly. Passive strategies are cheap and often more practical.

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But there's one thing you should never do. And that is to pay active' fees for passive' performance.

Which is why it's good news that the closet tracker' fund may be on its way out.

The best thing to happen to financial industry fairness

It's easy to criticise regulators for poking their noses in and interfering in free' markets. But at least one major intervention by Britain's financial watchdog in the last few years has been very welcome indeed the Retail Distribution Review (RDR).

Put simply, the RDR stopped financial services companies from paying commission to financial advisers. That one shift in the industry's incentive structure has probably done more than any other rule change to make the whole business fairer to consumers.

In the pre-RDR days, many advisers made their money through commission, rather than charging upfront fees (we always used to emphasise the importance of finding a fee-only financial adviser).

A client would approach them and ask for advice on where to put their money. This advice would be free' to the client. Advisers would instead be paid by providers. So a fund management group might pay the adviser a percentage of the money he or she put their way.

It's clear to anyone without a stake in the system that this way of paying people is riven with potential conflicts of interest. Advisers are meant to act in their clients' best interests. But commission-funded financial advisers basically operated like estate agents they were paid by the seller, not the buyer.

In turn, this meant that fund managers focused on persuading financial advisers to sell their products not on persuading consumers to buy them. That meant focusing on how much commission they could pay, rather than on providing the best products.

That's why fund fees remained stubbornly high, even although fund managers operated in an apparently highly competitive market. The people directing the most money into the funds weren't worried about charges commission was what mattered.

That's all changed now.

Commission has been banned. Advisers get their fees directly from clients, rather than indirectly via commission. As a result, they have no incentive to favour any particular fund manager.

Instead, they have every incentive to go for products that genuinely offer their clients the best chance of making a good return. Because when clients understand how much advice actually costs, they expect to make a decent return.

This is why investment trusts have grown a lot more popular in the last year or so. Same goes for the ongoing rise in passive' investing. A simple change in the incentive structure of the financial industry has done more good than reams of nitpicking and box-ticking ever could.

Fund managers are now being forced to compete based on the quality of their products. That's great news for boutique managers who have always prided themselves on performance. And it's bad news for bloated, complacent managers who have spent their careers focusing on nothing more than brand-building and asset gathering (the more money you can attract into a fund, the bigger the fees 1% of £1bn is a lot tastier than 1% of £10m).

The death of the closet tracker

The latest casualty of the post-RDR world is the closet tracker'. A closet tracker is a fund that basically tracks its underlying index (like a passive fund) but employs an expensive human manager to do so (like an active fund).

So you get passive performance at expensive active prices.

But these funds' days are numbered. For one thing, a group of investors in Sweden is taking a provider to court for allegedly mis-selling closet trackers. That'll rattle anyone over here doing the same.

And now, the smarter fund managers are publishing a figure called active share', to prove that their funds are anything but closet trackers.

Neptune Investment Management is the first to make the move. Active share', notes the Financial Times, "measures the degree to which a fund's portfolio differs from that of its underlying index".

The point is this if you want to beat the index, you have to be different to the index. Of course, simply being different doesn't necessarily mean that you will beat the index there's no guarantee of that, and you might wildly underperform. But at least it shows that you are doing what you are paid to do actively managing.

A figure of zero means a fund is no different to the underlying index. A figure of 100 means it's entirely different. "A level of above 60 is viewed by many as the sign of a genuinely actively managed fund."

As you might expect, the fund groups who are most keen to reveal their active share' are bound to be the ones who score highly on the measure others lining up with Neptune include Baillie Gifford and Threadneedle.

But it's a start. And the more companies who start publishing active share', the more pressure it puts on other fund groups.

Can you spot a closet tracker?

If you own a fund or are considering one, how can you find out if it's a closet tracker or not? It's not always obvious. But I'd look for two things.

Firstly, look at the top ten holdings, and compare them to the top ten companies in the benchmark' index. For example, if it's a fund investing in UK blue chips, compare it to the FTSE 100. If the two look very similar, chances are it's a closet tracker.

Secondly, look at the past performance. If it doesn't deviate much from the underlying index over a good few years, then again, chances are it's a closet tracker (and even if it's not, you'd be as well using a tracker).

If you reckon you've got one, then sell it and either find a decent passive fund that will do the job for less. Or find an active fund that actually tries to deliver active performance.

We're big fans of passive investment. But we also think that some active funds are worth looking at. We're particularly keen on investment trusts. If you're not already a subscriber, you can get access to the MoneyWeek investment trust portfolioand get your first four issues free here.