Are you in a closet tracker?
You can see why an active fund manager would copy the market, says Sarah Moore. But doing so as an investor is bad news.
Inadvertently buying a closet tracker fund is like spending "hard-earned savings on a new Ferrari, only to find several years later that there was a Fiat engine under the bonnet", writes Madison Marriage in the Financial Times. This sounds about right. A "closet tracker" is a fund that to all intents and purposes just copies its underlying benchmark (like a cheap "passive" fund), but charges the fees associated with having an expensive human manager ostensibly trying to beat the benchmark (like an "active" fund).
You can see why active managers do this it's less risky career-wise for them to lag the index slightly than to make big bets and come a cropper. But it's bad news for investors it means you end up paying well over the odds for performance you could get a lot cheaper elsewhere.
We've talked a fair bit in the past about avoiding these rip-off funds and now a European financial regulator has just released a report on the subject. The European Securities and Markets Authority (Esma) scrutinised the performance and disclosure documents of a total of 2,600 funds across Europe and announced this month that 5% to 15% of actively managed retail equity funds "could potentially be closet indexers".
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
This sounds a little light to us and it's quite likely that the true extent of the problem is worse. Asset managers SCM Private reported back in 2013 that as many as 46% of UK equity funds could be "closet indexers". Academics in the US and Europe have also published research which suggests that, in countries such as Sweden and Poland, this is the case for more than half of domestic equity funds.
Critics have called on Esma to name and shame the culprits, opening them up to the same kind of reputational damage and fines experienced by banks involved in the payment protection insurance (PPI) scandal. However, Esma says that it is not its place to do this, urging national regulators to carry out further investigations instead. So far, Norway's financial regulator is the only one to have publicly sanctioned companies, but investigations are ongoing in the UK, Ireland,Luxembourg, Denmark, Germany and Sweden.
Interestingly, the problem of closet tracking is a lot less prevalent in the US, despite it being the world's largest asset management market. Closet trackers make up 15% of assets in local equity products there, which SCM puts down to the fact that investors are able to see every holding in their fund online. "It is very difficult to get away with closet tracking with that level of transparency."
Given that we're not likely to see this practice catch on in the UK anytime soon, there are ways you can avoid the closet tracker trap. For example, funds that focus on a relatively small number of companies ("concentrated portfolios") are less likely to be simply tracking an index and more likely to be taking high-conviction bets. You can also compare a fund's top ten holdings against its benchmark; too much crossover might point to it being a closet tracker. And, of course, you could just switch to a passive fund at least that way you know exactly what you're paying for.
Sign up to Money Morning
Our team, led by award winning editors, is dedicated to delivering you the top news, analysis, and guides to help you manage your money, grow your investments and build wealth.
Sarah is MoneyWeek's investment editor. She graduated from the University of Southampton with a BA in English and History, before going on to complete a graduate diploma in law at the College of Law in Guildford. She joined MoneyWeek in 2014 and writes on funds, personal finance, pensions and property.
-
The top stocks in the FTSE 100
After a year of strong returns for the UK’s flagship index, which FTSE 100 stocks have posted the best performance in 2024?
By Dan McEvoy Published
-
A junior ISA could turn your child’s pocket money into thousands of pounds
Persuading your child to put their pocket money in a junior ISA might be difficult, but the pennies could quickly grow into pounds – and teach them a valuable lesson about money
By Katie Williams Published