Closet trackers: have you bought a duff fund?

When you invest in the stockmarket via a fund, you can opt for a "passive" or an "active" approach. Passive funds simply aim to track a stockmarket index. As a result, they are low cost. Active funds aim to beat the market, and employ expensive managers to do so. These managers promise to hunt down neglected areas of the market or follow a strategy that will lead to market-beating returns. They may not deliver, but some investors are willing to pay more in the hope that they will.

Sounds fair enough. The trouble is, some investors are paying active fees for passive performance. We're talking about "closet trackers" where an active manager picks a portfolio that is little different to the index, so that their performance "hugs" the benchmark. In effect, it's like paying Savile Row prices for an off-the-rack high-street suit.

Closet trackers exist partly due to career risk managers realise that following the herd can be the best way to keep their job. Long periods of mild underperformance are generally tolerated, but even temporary significant underperformance a risk for anyone taking bold bets outside the mainstream is not.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues 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

Sign up

How can you tell whether a fund is a closet tracker or not? One way is to look at its "active score". This measure, developed by Notre Dame's Martijn Cremers and Yale's Antti Petajisto, measures the difference between a fund's portfolio and a benchmark index. A pure tracker will have an active score of 0, while a fund which doesn't own any stocks in the index will have one of 100. Funds with active scores of less than 60 are considered closet trackers.

Fund researcher Morningstar this year found that while the average European equity fund had an active score of around 70, around 20% had scores of below 60.

Another red flag is the number of different positions a fund holds. A few years ago I spoke to a manager who held a huge number of stocks. I asked which she was most bullish about. "I'm equally passionate about all of them" was the response. Unsurprisingly, her fund tended to follow the market closely, even although her active score wasn't particularly low. So conviction matters.

A classic study by Danny Yeung of University of Technology Sydney found that a selection of portfolios made up of each fund manager's top 20 stock choices beat the market by an annual average of more than 4% a year between 1999 and 2009. The top five choices did even better, though they were significantly more risky. So if you're going to pay up for active management, look for funds with relatively concentrated positions ones that are taking big, high-conviction bets as well as those with a high active score. Otherwise you might as well just stick with a cheap passive fund.