Is Your ‘Actively Managed’ Fund Following An Index But Charging A Premium?

A recent investigation conducted by the UK’s Financial Conduct Authority (FCA) has come to the conclusion that British investors have £109 billion tied up in ‘closet tracker funds’ that are overcharging them on fees. The regulator defines a ‘closet tracker’ as a fund that claims to be actively managed, and charges a level of fees that reflects that, but actually does little more than track the index it should be trying to beat. And because a passive tracker fund doing roughly the same thing charges a fraction of the fees, they actually provide investors with better returns in most cases. Same result, lower fees.

An index is a collection of companies grouped together by an index creation company such as FTSE, S&P or MSCI designed to reflect the performance of a certain section of the stock market. In the case of the FTSE 100, the index is made up of the 100 largest companies on the London Stock Exchange and designed to reflect the average performance of the UK’s public ‘large caps’. The FTSE 250 is the next largest 250 companies by overall market value and represents the overall health of the LSE’s ‘mid-caps’. Other indices are designed to represent particular industries, such as technology, biotechnology, manufacturing and so on.

Index trackers simply invest in all of the companies that make up an index and with the same weighting. Weightings can vary from index to index but most commonly reflect the relative size of a company compared to the combined market capitalisation of all of the companies that make up an index. Because doing so is a technical set-up that doesn’t require highly paid ‘stock pickers’ as fund managers, supported by a team of analysts, index-tracker funds can charge rock bottom fees as low as 0.1% per annum.

Some zero-fee index trackers have even recently been launched by providers such as Fidelity. Their strategy is to take a small loss on basic products and make money from investors elsewhere, such as through brokerage fees.

Several studies, including an extensive piece of research conducted by fund data and research company Morningstar that assessed the performance of 9400 Europe-domiciled funds between 2008 and 2018, have demonstrated that a minority of active funds actually beat the index they are benchmarked against. The Morningstar study found that fewer than 25% of actively managed funds beat their index.

Perhaps in realisation of the fact that few of them actually succeed in delivering index-beating returns for their investors, despite charging significantly higher fees than passive trackers, more and more fund managers appear to have begun to stealthily track the index with most of their picks. This provides them with a safety net that means they won’t fall significantly short of the index’s returns, while hoping a minority of funds invested independently of the benchmark will beat it. And if not, the damage will be limited.

One example given is that of the Scottish Widows UK Growth fund. It invests mainly in large cap UK companies with the stated aim of beating the FTSE All-Share index. It charges investors an annual 1.46% management fee. A passive fund tracking the index can charge as little as 0.1%.

The FCA measurement of a ‘closet tracker fund’, is one that exhibits a performance tracking error from the benchmark of less than 1.5%. The Scottish Widow’s fund’s is 1.37%, indicating its make-up is very close to that of a passive tracker. But for the price of a management fee that is more than 1% higher per year.

Closet trackers appear to be a growing problem. In 2016 the European Securities and Markets Authority estimated as many as 15% of the retail funds offered to everyday investors could be ‘closet trackers’ charging unjustifiably high fees.

How do you tell the difference? A good clue to compare the performance of an actively managed fund to that of the benchmark it is trying to beat over several years. If it is almost identical, the fund might well be a closet tracker. Another indicator will be if the fund’s top 10 holdings closely correlate to the companies with the largest weightings in the benchmark index.