The biggest rip-off in fund management today

There's nothing useful I can add to the commentary about the horrific attacks in Paris on Friday night, except to express my sympathy for the victims and to sincerely hope that neither you nor your loved ones were hurt.

From an investment point of view, these things are similar to natural disasters. Horrendous and tragic as they are, the impact is short-lived relative to all the other factors influencing markets.

The political impact will be more complex (and we'll look at that in more detail as it becomes clearer), but again, just one small part of the jigsaw puzzle.

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From a human point of view, we just have to get on with life and understand that the ideals that our society, at its best, stands for are valuable and worth defending.

So let's talk about something far more mundane tracker funds

Active versus passive and one nasty surprise in the middle

We often talk about active' versus passive' investing. This is a bit of a misnomer there's no such thing as passive' investing. Every investment choice you make is an active one. Keeping money in cash is a choice. Putting money into the market is a choice. You are an active' investor whether you like it or not.

Here's what we mean when we talk about active' vs passive'. You choose to invest in a market let's say it's the FTSE All-Share. Presumably that's because you think that the All-Share will do well (off the back of a British economic recovery, say), or because it's a good way to diversify your portfolio.

Now the question is: how do you invest in it? You have a choice. An active' fund manager will try to beat the market. He or she promises to do better than the index their fund will go up by more than the FTSE All-Share. In return, the manager takes a chunk of your investment and pockets it every year.

A passive' fund, on the other hand, doesn't promise to beat the market. It'll just track' it. So you will get the same return as the FTSE All-Share (less costs). This is a simple strategy and a simple promise, so it costs less than the active fund.

So that's your choice. Do your research, pay up for active' management, and hope that the manager beats the index (rare, but it does happen). Or go for a cheap tracker fund, and be confident of getting the return on the index.

It sounds simple. But there's a third option that offers the worst of both worlds. This is the closet tracker'.

Closet trackers and career risk

Closet tracking is entirely the product of a risk that you as a private investor don't have to run at all. It's called career risk'.

You see, active fund management is hard. Beating the market is hard. That's because markets are pretty efficient. They're not as efficient as the academics like to pretend, which is why things like 2008 can happen, apparently out of the blue. But at the same time, on a day-to-day basis, outwitting the market is not easy.

The trouble is, fund management groups make money by attracting investment into their funds. They charge a percentage of the assets under management. So for most, the goal is to gather as many assets as possible, then harvest a nice chunk off the top.

As an active manager, that means that your ultimate goal is not to beat the market. It's to avoid being ranked bottom of the heap for too long. If you're on the bottom, it makes it very hard for your fund house to attract cash to your fund. If that happens, then before too long, you'll get fired. That's what we mean by career risk'.

As a result, the main temptation for the mediocre manager is to hug' the index. If you do a little bit worse than the benchmark each year, then you're not going to top the league tables, but nor are you going to come bottom.

It's like that old joke about the two guys in the jungle. They spot a lion and one of them pulls a pair of training shoes out of his bag and starts putting them on. His pal says: "Why are you doing that? You'll never outrun it." And he says: "I don't need to outrun the lion, I just need to outrun you."

That's the rationale for closet tracking' in a nutshell.

The end of the rip-off

This is a real rip-off. You pay a lot of money for active management. So if you're actually getting passive management instead, then you're effectively being mis-sold to.

The good news is that its days may be numbered. More and more attention with more and more calls for regulatory action is being drawn to the phenomenon. According to this morning's FT, new research carried out by four academics in Europe and the US suggests that "investors have been overcharged in at least 20 of the world's largest investment markets".

In Sweden and Poland, "more than half of the assets in domestic equity funds" are in closet trackers. It's nearly as bad in Canada, Finland and Spain, where the number is more than 40%.

Carl Rosen of the Swedish Shareholders Association reckons the answer is simple: "Ban all active funds that charge more than 0.8% in fees, have a tracking error of below 4% and an active share of below 40%" (active share measures how different a fund is compared to its benchmark).

That's not likely to happen soon. But if you want to avoid closet trackers, then find funds that have a fairly narrow focus (they hold a relatively small number of shares); check out the top ten holdings and compare them to the benchmark (if they're very similar, you might be looking at a closet tracker); and if in doubt, just go for the passive option.