The FCA’s value-for-money crusade on behalf of investors, launched with its 2017 Asset Management Market Study, identified weak price competition as evidence of poor value.
I have argued in this column that this reflects a fundamental flaw in the FCA’s understanding of competition in asset management.
As a follow up the FCA has turned its attention to ‘closet trackers’. Here I have more sympathy with the FCA, although its remedy – fee rebates – is another missed opportunity to improve outcomes for investors.
What is a ‘closet tracker’ fund?
Essentially they have two features – firstly, they deliver returns very similar to the underlying market(s) in which they invest by limiting the risk they take (the ‘tracker’ element); and, secondly, they do not adequately disclose this behaviour (the ‘closet’ element), enabling the fund to charge (higher) active fees.
How prevalent is it?
Although suspected for years, the European Securities and Markets Authority (ESMA) brought this issue into the public domain with a study published in early 2016. The European markets watchdog applied various definitions of closet tracking, adopted now more broadly, to identify that potentially up to a sixth of actively managed equity funds on the continent overcharged on this basis.
The study was followed up by a number of national regulators to see what was happening in their own backyards.
In Sweden the regulator identified more than a dozen fund management firms that adopted very low risk strategies; BaFin in Germany found a few cases while in France the regulator could not find any evidence of closet tracking in its home market!
In contrast, in the UK the FCA Market Study spoke of over a £100 billion tied up in funds that hugged their index or benchmark.
But is this really a problem?
ESMA and others have generally relied not on what is said, for example in marketing literature, but on portfolio metrics. These include ex-post measures of fund performance relative to the performance of an index (R-squared and tracking error) as well as an ex-ante measure of portfolio risk known as active share.The latter, first proposed by academics Cremers and Petajisto in 2006, measures the percentage of the portfolio that differs from the benchmark index.
The first problem is where to set the bar for these indicators? Cremers and Petajisto proposed 60% for the active shares measure, but why not 40% or 80%? ESMA used a range for the three indicators and came up with an envelope of between 5 to 15% of funds that could be classified as closet trackers.
The second problem is that none of the three measures takes into account the alpha generating capability of the manager or opportunities in the market or strategy.
Some managers or strategies may need a lot of risk to extract a little alpha; some others may be able to extract a lot of value from only a small amount of risk.
The third problem is that there may be period specific factors that can complicate the analysis.
For example, a 2016 study of European large cap funds by Morningstar found that, on their measures, the asset weighted share of closet index funds was around 35% in 2009-10 compared to around 15% before and after this period. Clearly, the global financial crisis saw active managers rein in their risk taking.
Although I have not seen or heard of managers deliberately setting out to miss-sell active management (ex-ante closet tracking), my own experience suggests that we should be concerned with overpaying for, in effect, ex-post closet tracking due to either poor product design or weak investment processes or talent.
An active manager taking sufficient risk but unable to generate significant alpha is an occupational hazard – caveat emptor; as it says on the tin, performance cannot be guaranteed. This is not a good outcome for investors who have paid a full active fee.
However, it is arguably not as bad as disappointing results that derive from poor product design or investment processes which unduly constrain the amount of risk that is actually taken.
I have seen both, including overzealous independent risk management functions that use finance theory or proprietary trading floor practices to override the discretion of the front line manager, as well as over-burdensome house or team investment processes that have the same result. And, more often than you might suspect, managers low in confidence reflected in timid position taking.
Whatever the cause, I fear ex-post closet indexing is still out there. It may be a small percentage of the industry depending on how you measure it, but it has a disproportionate effect on perceptions. They tarnish active management and are fodder for the passive industry.
FCA's missed opportunity
Regulators and advisors have an important role to play in guiding investors away from such funds and managers.
However, here I fear we are again missing an opportunity. The FCA in the Butler article proclaims that £34 million has been repaid to investors in compensation presumably as a result of their investigation. Although this will be welcomed by consumers, in my opinion the FCA should have gone much further.
As I have argued in this column before, active asset managers do not compete primarily on price, although the FCA seems to believe that this is the key to unlocking value for money for investors.
Price should not determine where investors place their funds otherwise they risk ending up in poorly performing or unsuitable products.
Asset managers compete for funds under management – this drives their business models and profitability. They do not rely on price to secure funds as this does not protect them from poor performance, poor service or poor advice.
Does the rebate change the alpha capability of the fund manager or of the product? Should those investors who have received a rebate from their closet tracking fund stay in the fund? If not, should the FCA be satisfied?
Hit them where it hurts
No, they should not in my view, for two reasons. Firstly, closet indexers should be hit where it hurts most – by losing assets under management.
The best way of doing this would be to name and shame. Neither ESMA nor the FCA have chosen to do so, possibly because they fear that the basis for their judgement could be challenged, preferring instead to put behind-the-scene pressure on the industry to self-regulate.
Secondly, the FCA has not asked how the advisory industry could protect the lay investor from such outcomes.
Instead they remain fixated on protecting retail customers by regulating active asset managers directly rather than by helping them to receive smart advice and smart investment decisions from competent and professional advisory intermediaries across the whole of their savings and investment needs.
Increasing scrutiny from regulators and greater competition from low-cost passive vehicles have put pressure on closet index managers and products.
However, if this encourages managers to be more active when they do not have a strong alpha generating capability or simply results in lower fees for essentially a product investors did not want, then customers may not be best served.
Furthermore, investors should not have to wait for regulators to act in order to improve their investment outcomes, but should have help and support from accessible, affordable and professional advisors in order to make the right decisions in the first place.