Closet tracker funds

“Passive” investment funds or “trackers” invest in a basket of shares (or use derivatives) to mirror the performance of an underlying stockmarket or index (such as the FTSE All-Share or, in the US, the S&P 500).

Index funds don’t employ professional managers to decide which stocks to invest in, and so have relatively low annual management fees and transaction costs. The index fund won’t beat the market – it will underperform slightly after costs – but you can be fairly confident that it will manage to track the market.

Active funds do the opposite – they charge higher fees and employ professional stock pickers in the hope that they will beat the market and thus justify the higher costs (although often they fail to do so). If an investor wants to pay higher fees for the chance of beating the market, that’s up to them.

However, in some cases, an active manager will pick a portfolio that in practice is little different from the overall market. These funds are called “closet trackers” and are considered the worst of both worlds. They charge the high costs of active management, but only deliver a passive return.

There are many reasons why managers do this, ranging from outright laziness to a fear of getting fired if they underperform, even for a short period. In a recent study, the campaign group Better Finance estimated that at least 165 out of 1,0134 European active funds were “closet trackers”.

There are two ways to spot closet trackers. One is to look at the number of holdings a fund has. If a fund holds a large number of individual shares, it’s a sign that the manager doesn’t feel strongly about any of them. Another metric to look at it the “active share”. This compares how significantly a fund’s portfolio differs from its benchmark index. The higher the score, the better.