How to avoid investing in a closet tracker

A closet tracker commonly refers to a fund that charges the level of investment fee you associate with active funds, but does little more than produce returns in line with an index. Now the fightback against such products was begun in earnest with regulators weighing in last year. The Financial Conduct Authority (FCA) highlighted it as a significant area of concern in an in-depth study of competition in the asset management industry.

Earlier this month, meanwhile, the FCA said it has demanded that fees worth £34m be returned to investors by funds that did not make clear they weren't being actively managed, and in view of this charged too high a fee. The FCA said it identified 84 funds that could have been closet trackers, and made the providers of 64 of these change their marketing material.

>A closet tracker refers to a fund that charges the level of investment fee you associate with active funds, but does little more than produce returns in line with an index

The regulator has not said which funds these are, and while such regulatory interventions can be helpful going forward they often come after the damage is done. So it is a good idea to try to avoid such products of your own accord before you spend years paying unnecessarily high fees for performance you could buy more cheaply.

Mathematical metrics

Closet tracker funds may allude to potential outperformance on factsheets and charge for this, but not employ the skill or spend on the research to make this possible. So you need to check that active funds have the ability to deliver outperformance.

Professional investors often use mathematical metrics to show how a portfolio is built in relation to its benchmark. And such figures are increasingly available to private investors.

One such metric is the active share ratio, a percentage figure that shows at a specific point in time if a fund differs from its benchmark in terms of the companies it holds and how much it allocates to them. The higher the active share percentage, the more likely it is that the fund is actively managed. If an active fund has an active share ratio below 60 per cent then it merits further investigation.

Another metric, the R-squared, meanwhile, focuses on historical performance. The number can range from zero to one and shows how much of a fund's return is derived from movements in the index. Zero means 0 per cent of the fund's performance is due to changes in the benchmark index, while 1 means that 100 per cent is. Generally, a figure below 0.7 identifies some form of active management.

But these metrics are not always readily available. Some asset managers, such as Baillie Gifford, Liontrust, Neptune and Columbia Threadneedle, have started publishing active share on fund factsheets, but they are the exception rather than the norm. 

The Interactive Investor platform publishes the r-squared on its fund factsheets with a number of other metrics that can also help to identify active management.

However, other platforms are reluctant to provide more information because of what is already available and because more complicated metrics, such as r-squared and active share, require nuanced understanding. They argue that while such metrics can help you identify active and passive funds, they do not tell you what is a good fund. The metrics also need to be used in the right context.

"These are very sophisticated measures and you need a high level of understanding, so for most people they will not help," explains Laith Khalaf, senior analyst at Hargreaves Lansdown. "And they are by no means infallible. Some funds can have a high r-squared but have delivered good outperformance."

The process used by Fidelity International to analyse funds before adding them to its Select 50 list ensures that the selected funds tend to avoid mirroring or tracking an index.

What to check

Platforms and fund statistics can help investors avoid closet trackers, but many investors are still unaware that they are paying a high fee for what is in effect a basic tracker fund, and have been for many years.

Research conducted in December 2016 by Better Finance, a European consumer rights group, highlighted a number of funds as potential closet trackers, including 11 UK domiciled ones, although the performance of some of these has since improved (see below). Some of these were launched in the early 1990s by banks and insurance companies.

Source: FE Analytics, as at 12.03.2018, Better Finance

Better Finance also said that the UK has a transparency issue regarding funds, as it could not determine if a fund was a closet tracker or not in the case of almost 300 other products.

But Sophie Kennedy, head of research at wealth management firm EQ Investors, says there are a number of ways in which you can check this. "Investors should hopefully [be able see what is in] the underlying portfolios [via the funds' annual reports] and in some cases a quick comparison between this and an index can often identify closet trackers," she says. "If the whole portfolio is not available, a top 10 holdings comparison is also often very telling."

Funds' top 10 holdings are readily available on monthly factsheets, or via data providers such as Morningstar.co.uk and FE Trustnet.

>The occurrence of closet trackers tends to be in mid- to large-cap markets, and more efficient markets such as the UK and the US

Gavin Haynes, managing director of Whitechurch Securities, says most platforms provide tools that allow investors to compare funds to their benchmarks via a chart. This graphic, he says, should better show if a fund consistently tracks its benchmark and underperforms by the same margin over time.

"[With an active fund] the key attribute you want to see over the medium to long term is a level of outperformance compared with what you would get from a passive alternative," he adds. "You can also look at the concentration of a fund's top 10 holdings, and if it is populated by [stocks] that are in the index then you know the manager isn't really taking [their own] approach.

Mr Khalaf says investors should not need complicated metrics to spot these closet trackers. "What you are looking for is modest underperformance [against the index] that is consistent," he explains. "But a significant underperformance [or outperformance] probably means [the fund] is active."

The biggest problem with closet trackers is not that they track an index, but rather that they mislead investors about doing so, and charge a higher fee for a service – active management – that they do not provide. 

A fund that tracks an index usually underperforms its benchmark due to fees, but the margin of underperformance will be consistent. The more expensive the fund, the greater the margin.

A tracker fund should be clearly labelled and have a lower than average cost. A UK equity tracker, for example, should cost in the region of 0.1 per cent.

"You have to have a look at your funds' performance," says Mr Khalaf. "What is wrong with closet trackers is that every year they underperform after the relatively high fees are deducted. So what you're looking for is long-term, consistent underperformance."

However, index underperformance does not necessarily mean a fund is tracking an index, as all genuinely active managers have periods of underperformance. Mr Khalaf says if you look at a fund's track record over at least five years and whether it has consistently underperformed, this should allow a manager's natural performance cycle to be taken into account, while also helping you to spot closet trackers.

"If there has been long-term underperformance and no change of management in the fund, you have to question whether you should remain invested," he adds.

Where to look

Closet tracking funds are more common with some types of assets than others, for example large-cap UK equities. This is due to a number of reasons.

The UK stock market is quite efficient in that the share prices of companies change quickly in reaction to changes in the outlook. This makes it harder for active managers to outperform. There are also many funds covering this area, in part because of investor demand as many have a home bias. There are more than 260 funds in the Investment Association UK All Companies sector, with £178bn in assets under management. Many of these are focused on larger companies, although the sector also includes mid-cap and all-cap funds.

Because there is a high demand for UK equity funds and a massive number of funds for investors to sift through, there are a number of sub-optimal products on the market.

"The occurrence of closet trackers tends to be in mid- to large-cap markets, and more efficient markets such as the UK and the US," says Ms Kennedy.

The US large-cap market, as measured by the S&P 500, is arguably more efficient than the FTSE 100. However, it does not suffer as much from oversupply and bias issues. 

And you are less likely to find closet trackers in areas such as Europe and emerging markets equities, and fixed income. However, UK investors may not be as familiar with the benchmarks in these areas and, for example, not know what the largest constituents in them are – useful knowledge when trying to spot closet trackers.

"Where the index is less well known, investors may not have a good knowledge of the largest companies, which can make it more difficult [to spot closet trackers]," says Mr Haynes. "But charts and ratios are all good indicators."

He also points out that index providers publish factsheets on their indices that are freely available on their websites, so you can see how a fund and its positioning compare to a benchmark.