Why closet index trackers need to be regulated out of existence

The point of most actively managed investment funds is to beat the market, but in order to beat the market, they must, in some way, be different from the market.

Generally speaking, the more different an investment fund is from the market, the more chance it has of outperforming.  On the other hand, the more similar it is, the less chance it has of outperforming.

If that’s the case, why do so many actively managed investment funds mimic the market so closely?  Is there an epidemic of closet index trackers in the UK?

This problem was highlighted in a recent report by SCM Private (which is available on their website).  The study looked at investment funds which benchmark themselves against the FTSE All-Share.

The key findings were that:

  • A typical fund will be about 40% identical to the index
  • Almost half of all funds investigated were “closet indexers” (defined as being less than 60% different from the index)
  • Funds that were more than 50% identical to the index had underperformed by 1.1% per year over the past five years, while funds that were more than 50% different had outperformed by 1.6% per year

Why active fund managers stick close to the market

Although it’s generally true that being different from the market creates more opportunities to outperform the market, it also creates more opportunities to underperform the market.  Most retail investors buy funds that have recently beaten the market and sell funds that have recently fallen behind the market.

The result is that many fund managers are terrified of underperforming in the short-term because they’ll lose investors.  If they lose investors, they will lose assets under management, which will reduce their management fees, which will possibly cost them their jobs.

That’s why many investment managers hold the same investments as the market.  If they invest in a way that’s very similar to the market, then they can’t underperform by much.  If they don’t underperform, then retail investors are likely to stick with them even if they don’t outperform.  That’s because funds are like bank accounts; most people find it easier to stay put than to switch.

Eventually, even a closet indexer will get lucky and outperform the market for a short while.  When they outperform, they’ll pick up new investors and new assets under management.  If they’re very lucky, they may win an award for their “skill”.  More investors will flock to them if they advertise the fact that they’ve won an award, and they can make a tidy sum from the management fee with very little effort or skill.

How to spot a closet index tracker

I doubt that many people actually want to invest in these closet index tracking funds, so how do you spot them?

A simple and usable measure in the fight against closet index trackers is known as “active share”.  It’s easy to calculate and gives a meaningful indication of how closely a fund mimics its benchmark.  It’s also the measure that was used in the report from SCM Private.

It works like this:

  • Calculate the weight of each stock in the benchmark index
  • Calculate the weight of each stock in the fund (which is zero if a stock isn’t in the fund)
  • Calculate the absolute difference between the weight of each stock in the index and the weight of that stock in the fund
  • Add up those differences
  • Divide the total difference by 2

A fund that is exactly the same as its benchmark will have an active share of 0%, while a fund that holds nothing from its benchmark will have an active share of 100% (and probably needs a different benchmark).

According to the study, the average active share of funds that are benchmarked to the FTSE All-Share is 60%, while only 24% of funds were considered to be “radically different” from the index, with 70% or more of their assets invested differently from the index.

For comparison, my model portfolio is also benchmarked to the FTSE All-Share.  It has 28 holdings and is split 50%, 33% and 17% between large, mid and small caps.  It has an active share of 76%, which puts it in the “radically different” category, which I guess is to be expected as I pay no attention to how its holdings compare to the index.

Unfortunately, there doesn’t seem to be any easy way to find active share for funds, so that’s something that Morningstar and the other information providers need to work on.

A minimum active share should be mandated by regulation

Currently, unit trusts and investment trusts have regulations which ensure that they are reasonably diversified.  It is becoming clear that actively managed investment funds need to have additional limits imposed upon them to ensure that they are offering something of value rather than simply an expensive closet index tracker.

I think two measures that should be regulated are active share and turnover ratio, although only active share is relevant to the current discussion.

Given that the average actively managed investment fund appears to have an active share of just 60% and that many funds have an active share of less than 50%, I think there should be a mandatory minimum active share of 50%.

A minimum active share of 50% is not aggressive and does not push managers to be “radically different” from their benchmarks.  However, it would ensure that a fund is more different from its benchmark than similar, and a minimum level would at least stop active funds from being nothing more than expensive index trackers.

Active funds must be truly active, or to put it another (better) way:

“Active management is not about activity, but about ignoring benchmarks” – Aberdeen Asset Management

Author: John Kingham

I cover both the theory and practice of investing in high-quality UK dividend stocks for long-term income and growth.

2 thoughts on “Why closet index trackers need to be regulated out of existence”

  1. John

    I understand where you come from but I don’t think that the regulator should intervene here. There are other issues where they are more needed at this moment: pension liberation, unauthorised investments, capital adequacy etc.

    This is a free market out there for investors and advisers to choose from and competition is a good thing.

    If you read Peter Lynch book – Up on Wall Street, he made an interesting affirmation that although he offered a lot of outperformance, the majority of his clients actually lost money. Yes, they lost money, because the fund was very volatile, and they bought him high and sold him low.

    Comparing this with Neil Woodford, where his clients made money as he minimised volatility, even if the performance in the last years was pedestrian due to managing very large funds.

    I don’t think there is only one answer to this question.

  2. I still think regulation is required because a free market only works to the benefit of the public when they have adequate information. So the minimum requirement should be that active share is at least disclosed, but my preference is that, like diversification, active share has a regulated minimum level (and turnover ratio should have a maximum allowed value of 50% or thereabouts).

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