Are you in a closet tracker?

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".

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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.