Get out of the closet

Get out of the closet

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It is common for investment funds to be managed with reference to a published index, in part to allow investors to have some indication as to how it might perform in the future.  Over the long term, it is reasonable to expect a fund which invests entirely in large US companies to exhibit performance which is closer to the S&P500 index than to the Japanese Nikkei 225 for example.  A relevant benchmark index also provides something which investors can use to compare with the historic performance of a fund.

The manager itself may use the benchmark purely as a comparator for performance or to define the potential pool of assets which it may contain.  Alternatively it may play a more involved role in the management of the portfolio.  If the portfolio is created to match (as closely as possible) the index’s composition, it is referred to as a ‘passive’ or ‘index tracking’ portfolio.  If the portfolio composition varies materially from that of the index, it is known as ‘actively managed.

However, the distinction between the two can be somewhat blurred.  For example, some managers construct their own index to represent the market rather than using a published one and then adopt a rules-based approach to determining which securities to hold.  Others may claim to manage the portfolio in an active manner but an analysis of its composition may reveal something very similar to that of the index.  The latter practice is often referred to as ‘closet indexing’ and has attracted criticism over the years from both investor advocacy groups and regulators.

You might well expect that, given your scribe’s previously expressed scepticism about the value of active management in delivering good outcomes for most investors, he would be enthusiastic that some active managers are reducing the extent of their bets against the market.  Particularly as they are taking those bets with investors money. 

However, with true index funds costing as little as under 0.1% annually, managers competing in that space have limited economic rationale to justify their approach to their shareholders unless they are managing large amounts.  Charging what are inevitably higher fees for active management while keeping costs down by staying close to the index composition therefore represents a tempting option for some.

Regulatory concern also focuses on two other issues which may have a detrimental impact on investors:

  • Investors could be expecting a more active approach than they receive and this could influence their decision-making process and
  • They may be exposed to different risk and return characteristics to those which they anticipated.

The fundamental issue is that the practice of closet indexing misrepresents a portfolio’s strategy to investors. It is important to note that index tracking, whether conducted openly or not, generally results in a fund performing close to its benchmark.  In fact, given that portfolios are subject to costs which indices are not, a slight underperformance is normal.  Among openly active funds, some outperform and others underperform their benchmarks.  However, as might be expected, the range of deviation is typically greater than for index funds as the portfolio compositions vary more.

Previous research has principally covered US funds but a recent study published by the European Securities and Markets Authority (ESMA) considered EU-domiciled equity funds.  The researchers looked at the annual returns of over 5,000 funds over the period 2010 to 2018, which were not categorised as index trackers and which had annual management fees of more than 0.65%.

It appears that some funds are prone to varying the extent to which their portfolios are close to the index, possibly because their managers’ inclination to pursue more active bets vary according to the economic conditions at the time. There is also some correlation between larger funds and the propensity to be a closet indexer, particularly where they have been established for a longer period.

Using a number of measures of potential closet indexing, some of which are disclosed by funds but others not, they sought to identify the extent to which each portfolio was different from its benchmark index.  They found that funds which appeared to be closet indexing were associated with lower performance, including on a risk-adjusted basis after costs.

Although closet index funds tend to charge lower fees than other active funds, they are still considerably higher than those of passive funds.  It therefore appears that while a manager’s costs in running a closet index fund are lower than those for an openly active one, only a small proportion of the savings is generally passed on to the fund’s investors.

For investors, there are several insights to be drawn.

  1. Where possible compare the published composition of a fund with that of its benchmark. Fund fact sheets tend to show at least the top 10 holdings and sometimes how these compare with the index weights.  While this does not tell the whole story (particularly for funds with large numbers of holdings), it provides a basis for further investigation.
  2. While past performance is not a reliable predictor of the future, compare the extent to which a fund’s historic performance matches that of its benchmark. Again, this information is commonly displayed on fund fact sheets or on the manager’s website.
  3. If you are looking for active management, your chances of finding it are apparently greater with smaller and more recently launched funds, although unsurprisingly most funds increase in size over time.
  4. If costs are important to you (and they should be, as every pound consumed in costs is one which you cannot spend yourself), then you could do worse than follow the advice of legendary stock-picking investor Warren Buffett:

“A low-cost fund is the most sensible equity investment for the great majority of investors.  My mentor, Ben Graham, took this position many years ago, and everything I have seen since convinces me of its truth.”

Given that positive index managers are retaining most of the cost savings that they make, you might also consider whether it would be worth purchasing shares in the manager itself in order to recover some of that benefit.  Since the costs of running a fund do not increase in direct proportion to the change in the fund size but the charges to investors generally remain the same, it is not uncommon for the share price of an investment manager to grow more quickly than those of its funds.