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Outing the index-hugger funds

'Closet tracking' has been labelled one of the most scandalous cons in the funds industry. But cracking down on it is proving difficult, says Rebecca Byrne.

It's been labelled one of the most scandalous cons in the financial industry. But cracking down on "closet tracking" is proving difficult, as investors in Sweden are now discovering. Back in December, thousands of shareholders took action against Swedbank Robur, one of Scandinavia's largest mutual fund managers, alleging it had mis-sold funds to retail investors. Essentially, they argued the firm was charging excessive fees for active management on two of its funds, when in reality the funds were passively tracking their benchmarks.

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Funds that "hug the index" while claiming to be trying to beat the market have been criticised by consumer groups across Europe, and the Swedish case was seen as a test case for legal action against the industry. However, the claim, which sought SKr7bn (£530m) in compensation for investors, has now been dismissed on a technicality: the National Board for Consumer Disputes said that judging it would require hearing oral evidence, which is not eligible at the board.Carl Rosen, chief executive of the Swedish Shareholders' Association, told the FT that the decision was influenced by big banks who were lobbying to have the case thrown out. He says he plans to appeal this "very disturbing" decision.

If he wins, it could be good news and not just for Swedish investors. In the UK, it's estimated that around £58bn of investors' money is tied up in closet trackers. That's almost a third of the total invested in UK equity funds, meaning that large numbers of people are paying for something they're not getting.

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So how can you make sure that you're not one of them? One idea that's been getting a lot of press over the past year is "active share", a measure developed by Martijn Cremers and Antti Petajisto, both formerly at Yale University. This looks at the extent to which a fund manager's portfolio differs from its benchmark index. If your fund has an active share of under 60 meaning that 60% of the fund's holdings mirror the index it is not considered an active fund.

Active share can be useful for spotting managers who are more likely to outperform, as well as closet indexers (see here for more). But an even simpler check is to compare the fund's long-term returns with its benchmark index. If they're similar, it may be a closet tracker. And even if it isn't, there's no point in paying for active management that merely matches its benchmark, when you could buy a true passive fund more cheaply.

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