Why Closet Index Trackers Need To Be Regulated Out Of Existence

26th Oct '13 by UK Value Investor

8 comments 13385 reads

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 5 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 opportunity to outperform the market, it also creates more opportunity to underperform the market. Most retail investors buy funds which have recently beaten the market, and sell funds which 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…

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djpreston

28th Oct '13

Good article and it highlights a particular bugbear of mine.

One of the biggest problems is when funds get very large - trying to be significantly active becomes harder and harder as liquidity in underlying positions becomes an issue - try running a £2bn fund - its a hell of a lot harder than a £200m fund. So many of the stocks you really "like" just arent viable for the fund at least if you want to take a big enough position to make a material difference.

A good example of this might be say the Unicorn UK Income fund, which was a very small, small cap income fund that has had the best record of any UK Income fund over the past several years. It was a lot easier for them to buy a holding in something like Castings (which was the biggest holding for a long time) back when it was £20m or less (as it was when I was buying it). Imagine now trying to put 5% or 6% of the fund into that now it is £350m in size. That would be about 9% of the company and, as of the time of writing, 1500 shares have been traded or a little over £6k. This means that the "style" of the manager has to change. This is something that investors need to be very aware of. One wonders if the surge of new money into the fund is just purely down to it being "top of the table" and do the people now recommending it realise how that performance came about and how things must now (inevitably) change?

This is why we see some funds "soft closing" or even "hard closing" when managers think that their funds have reached the maximum for the strategy that they use. This is, I feel, something to be applauded.

So, bringing the conversation back on track - you can imagine how difficult it is for the pension funds, the really big institutional players. Essentially they face two options - index completely or go to a quasi (closet) tracker route with managers being given a mandate of being +or - a certain % relative to the market either at sector or stock level just to add a certain amount of alpha. One wonders how the presence of the colossus funds affects the results of the survey?

In short, it is easier to be a private investor than a fund manager. It surprises me just how few people actually comprehend the issues involved.

Sorry if this went slightly off track. Just needed to vent a bit.

D

Edward Croft

Hi UKVI - great article. I couldn't agree more. I see this as massive mis-selling on the part of the fund industry. I want Stockopedia to be able to calculate active share and the historic alpha for all funds in the industry and highlight the managers that do really, truly add value. Other managers who don't should frankly be named and shamed and hounded out of the City.

UK Value Investor

22nd Nov '13

Hi D, I suppose size is eventually a constraint, but there's a lot you can do with 'tilting' or weighting a portfolio, even if you held everything in the index. That's what a lot of the active beta stuff does now (as I'm sure you're aware) like the Magic Formula funds.

But as you say for private investors life is much easier, at least in regard to not having billions to invest (unfortunately!).

Hi Ed, yes if the data monsters like you and Morningstar show active share that's a least a start. Also it depends how you define 'adding value', because not all managers can beat the market, of course.

So some can add value by improving the capital allocation decisions of the underlying companies, but then the index will benefit from that too so it doesn't show up in terms of beating the market, but it does improve the market relative to where it (and the underlying companies) would have been were it not for the fund managers input (such as Woodford apparently helping to derail the BAE merger a while ago).

cig

Big funds can't really do small caps, and may be limited in mid caps, but there's still plenty of scope for active management as a large cap manager so I don't think size is a valid excuse for closet indexing. £2B is <0.2% of the FTSE100 market cap so I don't think you're into problem territory yet. £200B maybe.

That said I don't think it's the role of regulators to intervene, they'll just make clunky rules that the motivated closet indexers will find tricks to work around wasting everybody's time and taxpayer money in the process.

red

24th Nov '13

Interesting article UKVI, thanks.

Let's turn the premise on its head to more accurately reflect reality:: "the more different an investment fund is from the market the more chance it has of UNDERperforming" (after fees).

The answer looks different when viewed from this angle.

What if I value weight the bread Index? Or, what if I closet track the Consumer Discretionary ETF? Or, I closet track the consumer staples ETF and sell out of the money calls on it. I'm still a closet tracker, no? Am I adding enough value to justify mutual fund fees? Probably not which is why ETFs exist in the first place and why they are the long term solution for the (very) passive investor.

13th Dec '13

Hi red, your point about underperforming is largely the point. Active managers don't like to underperform because they lose their jobs, therefore they will very often stick to the market average like glue.

As for your other points, really I'm talking about vanilla funds that just own individual stocks, not weird things that value weight the bread index! Although to be fair value weighting is is a big part of what I do, and it should produce a significantly different "active share" than the fund's benchmark.

I hear you. I can understand a public policy argument that says that the only thing that shouldn't be allowed is mutual funds (and retirement savings) that don't blow up and closet index tracking fits that purpose. Without it, a lot of working people are going to find out one day that their savings were invested in some crazy strategies.

Those of us that would like to take on the risk of deviating from the index have the option of ETFs of every description, value-weighted funds like yours, or self-directed stock-picking/investing as facilitated by resources like Stockopedia.

Why closet index trackers need to be regulated out of existence

Why active fund managers stick close to the market

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