Closet tracker funds

Tracker funds (trackers or index funds) are a type of passive fund that invests in a basket of shares (or uses derivatives) to mirror an underlying index (such as the FTSE All-Share). These funds don’t employ professional managers to decide what stocks to buy, and so carry relatively low fees. The passive fund will always underperform the market slightly after costs, but you can be pretty confident it will otherwise be able to track the market relatively closely.

Active funds do the opposite – they charge higher fees and employ stock pickers in the hope that they will beat the market and thereby justify their higher costs (although as we note in the piece above, they often fail to do so).

In practice it’s an arithmetical inevitability that both active and passive funds will collectively underperform the market. After all, for every winner in a trade there’s a loser. So in the end, the average investor gets the market return, less costs. The reason investors still put money into active funds is that they hope they’ll pick one of the winners, rather than one of the many losers.

The trouble is, to beat the market convincingly you need to take risks – perhaps by taking large positions in a small number of stocks. The danger then is that you underperform the market badly, even if only in the short run. This has in the past  led to some active managers picking portfolios that differ little to the overall market – although it is increasingly frowned upon. These funds are“closet trackers” and represent the worst of both worlds: they charge high active fees, but deliver a passive return.

There are ways to spot a closet tracker. An obvious method is to look at its past performance and how much it differs from the wider market. One metric to look at is the active share. This compares how significantly a fund’s portfolio differs from its benchmark index. The higher the score, the better.

Updated October 2018


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