Regulators Rightly Focusing on Closet Index Funds
Roberto Lazzarotto, Global Head of Sales
Funds that charge active fees but «hug» indices are a money-losing proposition; and regulators are closing in on this practice.
In the last 18 months, regulators in Europe have shined light on closet index funds. These are investment vehicles that charge an active-management fee but in reality closely track indices, eroding investors’ returns with unnecessarily high costs.
The increased awareness around the problem is a positive development, as is the possibility that regulators go further and impose new disclosure rules that would help identify pseudo-active funds.
Passive products offer investors exposure to an entire market or strategy at a low cost. For a higher fee, ‘active’ money managers promise a more efficient exposure to the same market, one with the potential to generate additional returns. Both are valid propositions.
Closet index products, on the other hand, present neither of those benefits. Instead, they remain in a territory of their own, accumulating high margins for the asset manager whose risk-taking is overpaid, at the expense of compounding losses for investors.
Assessing the problem
The offenders are no small group. In February 2016, the European Securities and Markets Authority (ESMA) estimated that up to 15% of UCITS equity funds in the European Union showed signs of potential closet index tracking.
In a much-awaited review of the asset management industry published last June,1 the UK’s Financial Conduct Authority (FCA) estimated the value of assets invested in high-fee ‘active’ British funds that closely mirror benchmarks at 109 billion pounds (123 billion euros).
These numbers serve as a base to calculate the wrongful fees many unaware investors are paying. And this is just one region.
Expensive, bad performers
In a seminal work2 on closet index funds in 2015, Professors K.J. Martijn Cremers and Quinn Curtis exposed the scope of losses born by investors of these funds. Cremers and Curtis showed that closet trackers are particularly bad performers and that, adjusted for their level of active share – or the ratio of holdings that diverge from a portfolio’s index – they are more expensive.
Cremers and Curtis defined closet index funds as those active-fee funds whose active share was below 60% – with 100% being a fund that doesn’t overlap with the index at all.
The need for more information
ESMA has reminded asset managers of their duty to provide information that is fair and clear. Included is the obligation of a fund, whenever it is sold as being referenced to a benchmark, to report the degree of freedom it has in relation to this benchmark; and indeed to state if the objective is to track the index.
The European agency, however, has acknowledged that current rules may not be enough to stop the plight of ‘index hugging.’ Among options, ESMA has said it will assess the need for further disclosures and consider the merits of developing a general definition of active and passive management.
I would argue that a definition of active vs. passive management would be a significant step towards protecting investors. It would elucidate what they are consuming in the same way that Nutrition Facts labels are displayed on food products.
Active share disclosure
In this sense, a sensible proposition could be the mandatory disclosure of funds’ active share. Such a requirement would be in line with an ongoing global trend of demanding better disclosures from fund companies – particularly when it comes to fees – and indeed of reforming the asset management industry to obtain more transparency.
Working on investors’ best interest
ESMA and the FCA are dedicating resources to see how reporting standards can be improved. Regulators in Sweden and Germany are also taking steps aimed at enhancing transparency. I believe this is the right path to follow.
Encouragingly, asset managers support changes that can help foster transparency and accountability in the industry. For example, the U.K.’s Investment Association, the trade body for Britain’s investment managers, has pledged to work closely with regulators to improve the disclosure of costs and charges and to help develop a more independent oversight of investment funds.
Reforming disclosure parameters to benefit the industry
Closet trackers cost investors money and taint the asset management industry’s reputation. This has the potential to affect the main channel for retail money flows into the financial system.
Asset managers have a lot to gain with increased disclosure requirements of investment products, and very little to lose from it. It’s promising to see regulators paying more attention to closet index funds. From professionals in the financial-services industry to investors, we all stand to benefit from a crackdown on this practice.
1 ‹Asset Management Market Study,› FCA, June 2017.
2 ‹Do Mutual Fund Investors Get What They Pay For? The Legal Consequences of Closet Index Funds,› Cremers, Martijn and Curtis, Quinn, Nov. 24, 2015.