By ALEX MOFFATT
Ireland’s Central Bank issued a press release in early November about a fine it had imposed on an investment company. The company, Mercer Global Investments Management Limited (MGIM), is not a big name in the investment world and the fine, of €117,500, is trivial in an industry that routinely deals in billions. It sounds like a small, local event. So why should anyone beyond those whose money was being invested by MGIM care? Because, though minor in itself, it provided yet another glimpse of a scandal through which millions of investors all over the world are unknowingly being ripped off: the scandal of closet index funds.
Index tracking is the simplest, cheapest way to invest. It’s an administrative task that requires no special investment strategies or cutting-edge research, so index funds charge exceptionally low management fees. Actively managed funds, on the other hand, tend to charge a whole lot more on the basis that they employ expert money managers to do research and implement supposedly market-beating strategies.
However, a disturbing number of funds that claim to be actively managed appear to be doing little more than tracking an index, while still helping themselves to hugely inflated management fees. This is what closet indexing means.
Tip of the iceberg
Returning to the case of MGIM, it admitted that between July 2011 and December 2018, the prospectuses and investor information documents for five sub-funds had failed to disclose that these funds relied on an index-tracking strategy, and did not provide details of the index being tracked.
This case is likely to be only the tip of the iceberg in Ireland. It follows from a major review, carried out by the Irish Central Bank and published in July 2019, that covered “all of the 2,550 Irish authorised UCITS funds classified as actively managed as at March 2018”.
The findings were non-specific but raised concerns suggestive of a lot of potential closet indexing. For instance, it found that “investors were not always given sufficient or accurate information about the fund’s investment strategy”, and that when giving information on past performance, “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”.
It’s what economists call information asymmetry, where the buyers know far less about the product than the sellers, so buyers can easily be ripped off.
To be clear, this is a global problem. Back in 2018, as reported by Robin Powell in an article on this website, the UK’s regulator, the Financial Conduct Authority, forced fund managers to pay £34 million to investors in closet index funds. In all, 64 funds were fined in this case, but experts felt this was only scratching the surface.
A large study of the issue was conducted by ESMA, the European Securities and Markets Authority, that was published in 2016. It examined a sample of 2,600 managed funds for the period 2012-2014 using various quantitative measures and concluded that “between five and 15 per cent of UCITS equity funds could potentially be closet indexers”.
That sounds conservative. An academic paper from 2015 concluded that, in Canada, about 37 per cent of assets were invested in closet index funds.
It could be even worse than that. Back in 2015, Robin Powell cited research that found that closet trackers accounted for more than half the assets in Swedish and Polish domestic equity funds, and more than 40 per cent of assets in Canada, Finland and Spain.
Spotting the cheats
Unfortunately, investment is a complex business and there’s no easy, instant way to spot a closet tracker. The most commonly cited method of detection is known as Active Share, a measure of the extent to which a fund’s holdings deviate from its benchmark index. If there is no difference at all from the benchmark, it’s safe to say the fund is a tracker, and the degree of deviation should indicate the amount of active management.
It’s often not a black-and-white issue. Managed funds can use indexing to varying extents. Often funds start life with a genuine, fully managed strategy but find this harder and harder to implement as the size of the fund grows. There’s a temptation as they grow to slide quietly toward indexing, while continuing to charge the same high management fees. Indeed, data analytics firm Peer Analytics concludes that more than a third of US equity mutual funds are so passive in their strategy that they “fail to merit a typical fee”.
Despite the promise of Active Share as a measure, it’s far from foolproof (Larry Swedroe raises some serious concerns here). Detecting closet indexing unfortunately requires a lot of slow, arduous work by regulators that are unlikely to have the capacity to keep a close eye on thousands of mutual funds. If the profits from closet indexing are substantial and the chance of detection is low, the problem is bound to persist.
A simple solution
From an investor’s point of view, though, there is a simple solution: seek out a low-cost index fund and don’t put your savings in a managed fund. The low charges provide an instant gain. But what about performance, you might wonder. The attraction of a managed fund is the hope that its skilled money managers will be able to beat the market.
But there’s little evidence to support this hope of outperformance. UK investment platform AJ Bell publishes periodic reports comparing passive and active funds, or “manager versus machine”, as it calls them. Its newly published report for 2022 finds that only 27 per cent of active funds outperformed the passive alternative in the year. That’s down from 34 per cent in 2021, and even over 10 years, only 39 per cent of active funds outperformed passive rivals.
That means your odds of outperforming are considerably worse than the toss of a coin. Defenders of active management might argue that the secret is picking the right fund to invest in. The best money managers will surely get you the best return, right? It’s easy enough to check which managed funds have performed particularly well over the past year or two. But how worthwhile is this information?
The Economist quotes some revealing data in this regard. It takes a baseline of the 12 months to March 2013. Suppose you picked one of the best-performing 25 percent of US equity mutual funds from that period. In the subsequent 12 months, just 25.6 per cent of those funds remained in the top quartile. To put it another way, had you picked a winning fund in March 2013, the chances are greater than 75 per cent that it would perform badly over the next 12 months. And year by year, it keeps getting worse. After two years, just 4.1 per cent of the original winning group remain in the top 25 per cent. After three years, it drops to a miserable 0.5 per cent.
Investing success is all about long-term performance, and there is a mountain of data to show that consistently outperforming fund managers are a vanishingly rare breed. And while they fail to perform, they continue to extract hefty fees. Low-cost index investing really is a no-brainer.
The message for regulators
Meanwhile, the message for financial regulators is clear: we’ve been talking about closet index funds for years, but they aren’t going away. Consumers the world over continue to be misled.
What investors need is a clear, concerted message from the regulatory authorities that blatant closet indexing is fundamentally dishonest and won’t be tolerated. And that means handing down much bigger fines than those imposed so far.
ALEX MOFFATT is a journalist, formerly on the staff of the Irish Times and then the Irish Daily Mail and Irish Mail on Sunday. He has postgraduate degrees in American literature, journalism and politics, and he lives in Dublin.
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