Closet index tracking is the dishonest, and sadly widespread, practice of fund managers charging for active management while simply hugging the benchmark. It’s the fund industry’s dirty little secret and it has been a systemic problem for years.
Morningstar has found that up to 20% of large-cap equity funds domiciled in Europe could fall into this category. That is broadly in line with the findings of the European Securities and Markets Authority, which reported on this issue in February 2017.
National regulators, however, have so far been slow to act and reluctant to take decisive action when firms are found to have stepped out of line.
The Norwegian regulator has been the most decisive. In March 2015, it ordered a large bank, DNB, to lower the fees on one of its most popular funds, or to manage it in a more active way. In March 2018, the UK regulator, the FCA, revealed that a number of asset managers had been forced to pay back £34m to investors overcharged by closet index funds.
Now the Irish regulator, the Central Bank of Ireland, has signalled its intention to get to grips with the problem in a report on its review of closet tracking among UCITS funds domiciled in Ireland.
The review involved detailed analysis on all of the 2,550 Irish authorised UCITS funds classified as actively managed as at March 2018, and its four main findings are as follows:
1. Investors were not always given sufficient or accurate information about the fund’s investment strategy in the Prospectus and KIID that affects their ability to make an informed decision on whether to invest in the fund.
2. Instances of poor governance and controls by fund boards.
3. Instances where the fund had a target outperformance against an index that is less than the fee charged to certain share classes in the fund. The result is that even if the UCITS provides a return at the upper end of its projections, investors in these share classes will not realise a positive return against the benchmark, as the fee charged will cancel out any outperformance achieved.
4. In some cases, in the past performance section of the KIID no comparator was included so that investors in these funds were not able to determine whether the fund, irrespective of performance, represented good value relative to its benchmark.
The Central Bank says it has identified 182 funds that can be classified as closet indexers. It has declined to name the funds, pending further inquiries to assess the extent to which customers were misled. It says it is prepared to make use of its “full suite of supervisory powers”, including financial penalties.
In the meantime, the Central Bank has warned fund managers to review the accuracy of their disclosures, giving them a deadline of March next year to address any shortcomings.
Commenting on the announcement, Derville Rowland, the Central Bank’s Director-General said: “Investors have a right to rely on the information (in fund documentation), and funds have an ongoing duty to ensure that this information is accurate and that the fund is managed in investors’ best interests.”
This move by the Central Bank of Ireland is, of course, encouraging. But the reality is that it’s still very hard for consumers across Europe to work out whether a fund is genuinely active or not.
If in doubt, investors should seek the help of a competent financial adviser. They will also find useful information on closet indexing on the website of the Brussels-based consumer group Better Finance.
