Imagine paying for full board in a top hotel, but when you arrive you discover you’re staying in a self-catering apartment. Or discovering that the chicken you’ve been putting in your sandwiches all these years is, in fact, reformed chicken, with added water, starch and milk protein. You wouldn’t be very happy. Closet indexers.
For decades, investors have invested in what they thought were actively managed mutual funds but were effectively very expensive index funds. With the money they could have saved by using genuine index funds instead, most could have paid for several luxury holidays — even a holiday home — with lunch at their very favourite chicken restaurant every day.
Recent research by four prominent academics in Europe and the US showed that closet index tracking is prevalent in all of the world’s largest investment markets, including the US and the UK. In Sweden and Poland, closet trackers, or benchmark huggers, account for more than half of the assets in domestic equity funds, and more than 40% of assets in Canada, Finland and Spain.
Let’s not beat about the bush here. These funds are fake goods. This is blatant dishonesty and systemic mis-selling on a colossal scale. So, what can be done about it?
Interestingly, the researchers found that actively managed funds charge lower fees and are more active in countries where there is greater competition from genuine index funds. So we must continue to educate investors about the benefits of using index funds, as well as encouraging fund shops to publicise them and journalists to write about them more often and in more positive terms.
We also need to press for tighter regulation. Thus far, only in Sweden and Norway have regulators really done anything to address this issue. Fund providers must be far more transparent about how actively managed their funds really are. In particular, each fund should publish its Active Share — or the proportion of the fund’s holdings that differs from the index.
But there is a third solution which would have a bigger impact, and far sooner, than the other two — legal action. There have been a few examples of individual investors taking fund managers to court, but what we really need are large-scale class actions. To date, the only such action has been in Sweden, where the national shareholders’ association, the Sveriges Aktiesparares Riksförbund, sued the second-largest fund house, Swedbank Robur.
The Swedish case was dismissed, but new research in the United States shows that there is a strong legal case against fund managers over closet indexing.
The paper, Do Mutual Fund Investors Get What They Pay For? The Legal Consequences of Closet Index Funds, is authored by Martin Cremers from the University of Notre Dame and Quinn Curtis from the University of Virginia; Cremers, incidentally, was one of the academics who first devised the notion of Active Share.
“Investors in a closet index fund,” say Cremers and Quinn, “are harmed by paying fees for active management that they do not receive or receive only partially.” The authors go on to say that there are two ways in which fund providers could be challenged under US law. Investors in closet index funds could either:
1. claim they have been misled by a fund’s prospectus and public statements regarding its investment style, which would provide a theory of liability under 11(a) and 12(a)(2) of the Securities Act; or
2. claim, simply, that they have been overcharged, which is covered by Section 36(b) of the Investment Company Act.
“Legal challenges to egregious offenders,” the paper concludes, “can reduce the scope of the closet indexing problem and increase the tools available to investors to spot problematic fund management.”
True, closet indexing is less of an issue in the US than it is elsewhere. Studies have put the proportion of active funds in the US that hug the index at between 10 and 15%. But even at that sort of level, millions of investors are being ripped off.
Furthermore, a high-profile case against one of the major players on Wall Street, or in the City of London, would go a long way towards raising public awareness. It would also make fund providers think very carefully before charging active fees for passive management, especially if the case results in a substantial fine.
Let’s be realistic. If we wait for the regulators to tackle closet tracking we’ll be waiting for a long time; and the industry will never address it, voluntarily, on its own. It’s time to hit the closet indexers where it hurts — in their pockets. Perhaps that will finally stop them picking ours.