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Shun the benchmark huggers

If you don't want the hassle of stock picking, you have two main options, says Marina Gerner. But whichever you choose, avoid the closet trackers.

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If you want to put your money into the stockmarket, but don't want to go to the effort and risk of picking individual stocks, you have two main options. You can invest via an actively managed fund that will charge a relatively high annual fee for a fund manager to invest your money in the hope that he or she can beat the market (unusual, but it does happen). Or you can use a passively managed fund that will charge a relatively low annual fee for tracking an index in other words, you'll get the return on the market (less costs), but there's no chance of beating it.

Each has its pros and cons. We like passive investment because it's cheap and simple, but if you're willing to do the legwork, a decent active fund can deliver (as MoneyWeek's investment trust portfolio has so far shown).

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However, there's one type of fund you should always avoid the "closet tracker". These are marketed as active funds and charge the same high fees, yet do little more than track the benchmark, like a passive fund. These "benchmark huggers" are "the active-fund-management industry's dirty little secret," as Andrew Clare of London's Cass Business School tells the Financial Times. But it's a secret that's increasingly hard to keep.

To measure just how active a fund really is, researchers Martijn Cremers and Antti Petajisto developed a metric in a 2009 Review of Financial Studies paper. "Active share" captures the proportion of a fund's holdings that vary from its benchmark. Closet trackers have an active share of below 60%; funds with active shares equal to or above 60% are "truly active".

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In a more recent study of funds across 32 countries (Indexing and Active Fund Management: International Evidence), four academics (including Cremers) from the US and Europe found that about 20% of global fund assets are invested in closet trackers. The number is particularly high in Sweden and Poland, where, as Madison Marriage notes in the FT, more than half of domestic equity funds could be described as closet trackers. In the UK, nearly a third of "active" funds are closet trackers. The proportion was lowest in the US, where they still amounted to 15% (see chart).

The study also looked at fees. Across the board, passive funds were much cheaper than active ones. But closet trackers were just as expensive as truly active funds. Globally, the average total shareholder cost (the total expense ratio plus other charges) was around 1.6%, compared to 0.35% for passive funds. In the UK, total shareholder cost was more like 2.3% for active funds and 0.62% for passive. That's a huge gap. It's little surprise that Carl Rosen, chief executive of the Swedish Shareholders Association, describes it as a "gigantic mis-selling phenomenon".

Regulators have been slow to act as Marriage notes, so far only Norway's watchdog has taken action against a company for selling closet trackers. But there are plenty of ways to protect yourself. Given that most active managers fail to beat the market over the long run anyway, you could simply go for a cheap passive fund from the start. Don't overpay for these either you can get UK-focused trackers charging below 0.1% a year (excluding broker costs) while even more exotic trackers (such as Japan) can be had for less than 0.2%. If you'd rather go active (or want to check if any of your existing investments are closet trackers), then below.

How to spot the duds

If you want to beat the index, you can't copy the index you have to take big bets. That means a truly active fund will usually have a relatively small number of positions, with a decent chunk of the fund in each. Sometimes it's easy to tell if this is the case for example, the Finsbury Growth and Income Trust holds just 26 stocks, of which the top ten account for more than68% of the portfolio.

Clearly that's a high-conviction portfolio there's no guarantee that it will beat its benchmark in future(though the trust has a good track record), but it certainlywon't just track it. For less obvious cases, compare the topten holdings from the fund factsheet with the top ten in thebenchmark index. If the fund holdings look similar to the index,it's more than likely a tracker. And compare its performanceto the benchmark you'll probably find it's neither hitting thehighs nor plumbing the lows.

The good news is that the growing popularity of passive funds,both in the UK and elsewhere, should force active managers toup their game the Cremers et al study (see above) also foundthat, in markets with lots of passive funds, active managerscharge less and tend to perform better. Indeed, the researchersnote that, in general, "truly active funds significantlyoutperform [both] closet indexers" and their benchmarks.

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