In the last number of years there has been a regulatory focus on active investment management and performance. A number of key regulators including ESMA, the CBI and the FCA have reviewed the market for potential hidden “closet tracker” funds and published their findings, with a number of funds providing inaccurate information in their investor disclosure documents as regards investment strategy.
WHAT ARE CLOSET TRACKERS?
Closet trackers, also known as closet indexing or index hugging, refers to the practice of fund managers claiming to manage portfolios actively when in reality the fund stays close to a benchmark.
IMPACT OF CLOSET TRACKERS
The issues around ‘closet trackers’ form part of a broader issue on the effectiveness of investor disclosure and the legitimate expectations of investors in respect of the service provided by some asset managers.
Closet trackers may result in:
- Investors making investment decisions based on an expectation that they will be provided with a more active fund management service than they receive in practice and, therefore, may be paying higher management fees than that usually envisaged for a passive/not significantly active management service;
- Investors being exposed to a different risk/return profile than they expect; and
- Asset managers not providing clear descriptions of how funds are managed in key disclosure documents such as the fund’s Prospectus and Key Investor Information Document (KIID).
Closet Trackers are now the focus of regulatory scrutiny and a clamp-down across Europe with many regulators conducting reviews into the practice.
Click here to find out more about the developments across Europe and different results of their findings.
COMMON METRICS USED TO SPOT A CLOSET TRACKER
Across Europe, regulators and ESMA have shown themselves adept at using data driven oversight to spot potential closet trackers, through large-scale data driven oversight using measures such as:
R-SQUARED
Similar to Tracking Error, R-squared measures the relationship between the portfolio’s performance and the benchmark’s performance. It is the proportion of variance of the fund performance explained by the benchmark performance. The higher the R-squared, the more similar the management style is to that of a tracker fund.
ESMA also used this metric in their study of potential closet trackers. In their study, if a fund was found to have an active share of less than 50%, a tracking error of less than 3% and a R2 of more than 0.95 (95%), it was classified as potentially being a closet tracker. Using a methodology which combined the three metric (Active Share, Tracking Error & R-squared) they found the following results:
| OTHER FUNDS FOR TRADITIONAL INVESTMENTS | OTHER FUNDS FOR ALTERNATIVE INVESTMENTS | |
|---|---|---|
| ENGAGE IN SHORT-SELLING | Yes | Yes |
| BORROWING | Max 25% NAV | Max 50% NAV (Art 100 (2) lit. a, CISO) |
| PLEDGE, OR TRANSFER AS COLLATERAL | Max 60% NAV | Max 100% NAV (Art 100 (2) lit. b, CISO) |
| MAX OVERALL EXPOSURE | Max 225% NAV | Max 600% NAV (Art 100 (2) lit. c, CISO) |
Across Europe, other regulators have conducted investigations into Closet Trackers using various methods.
Click here to find out more about other methodologies used and their corresponding results.
ACTIVE SHARE
Active Share examines how much of a fund’s holdings differ from its underlying benchmark, with the active share showing the percentage of the portfolio which does not coincide with the underlying equity benchmark. The active share varies between 0% and 100% – the higher this figure is, the more a fund’s management will be considered active. ESMA used this as one of the metrics in their 2016 study.
In conjunction with the Active Share metric, they used the above Tracking Error in their methodology. In their results, the following were classified as potentially being closet trackers:
- Funds with an active share of less than 60% and a tracking error of less than 4%
- Funds with an active share of less than 50% and a tracking error of less than 3%
TRACKING ERROR
Tracking Error assesses how closely a fund tracks a benchmark by comparing the performance of the fund to that of the benchmark. Passive strategies, which aim to replicate a benchmark’s return, often use tracking error to measure their success. This metric was used by both ESMA and the FCA in their respective studies.
In the FCA Asset Management Market Study, they provided the below diagram which displays the ongoing charges figure (OCF) compared against the tracking error. A low tracking error generally means a passive fund’s performance closely follows the benchmark. In their study, they found that there is around “£109bn in expensive funds that closely mirror the performance of the market (they have a tracking error below 1.5)” – these were found to be considerably more expensive than passive funds.
SUMMARY
The work by the FCA, ESMA, and other European Regulators on FCA Assessment of Value and on closet trackers over the last number of years shows the importance and value to the regulators of data, and their willingness and intention to use this to identify issues in the functioning and performance of the fund management industry.
It should also be noted that although the above metrics are useful tools as indicators of potential closet trackers, as the EFAMA has stated, these metrics should only be used as “a first step in the investigation of closet indexing”.
Closet trackers are the investment management equivalent of wolves in sheep’s clothing – with the spotlight well and truly on them, it is unlikely they are going to remain unnoticed in the future.
FUNDS-AXIS FCA ASSESSMENT OF VALUE SOLUTION
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