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By: Simon Danaher

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February 3rd, 2016

Alpha manager, beta performance?

Investment

[Estimated time to read: 2 minutes]

Regulators begin crack down on ‘closet indexing’ funds

Equity_funds_mis-sold.jpgAlmost one sixth of all actively managed equity funds may have been mis-sold.

This shocking statistic was released by the European Securities and Markets Authority (ESMA) earlier this week.

According to ESMA, around 15% of all equity funds which claim to be actively managed, may in fact be “closet indexing” or “index hugging”. That is, simply investing in a near-identical portfolio of stocks as the index or benchmark in their sector.

This means, rather than providing investors with a portfolio of carefully selected stocks which have been picked using the manager’s skills and expertise, investors are simply getting a fund which is no different from one which is passively managed

But the real problem is that investors will be paying substantially more, thinking they are buying into an actively managed fund.

It is these higher costs and the fact that asset managers are believed to be misleading their investors intentionally, which has led ESMA to describe it as mis-selling.

The findings came out of a study of 2,600 European funds over 2012-2014.

In the study ESMA sought to determine whether it could find any indication of closet indexing at an EU-wide level. It ran a series of quantitative tests which indicated that between 5% and 15% of UCITS equity funds could “potentially be closet trackers”.

The regulator then reviewed the documents given to clients and found it they “tended” to confirm the quantitative analysis.

ESMA said it is now going to work with national regulators to crack down on the behaviour, and there is speculation this could result in substantial fines for some asset managers.

So what’s the learning for you?

One could argue, owning one of these funds is like buying a Porsche, only to lift the bonnet and find a Fiat engine inside.

However, we think that’s a disservice to passive funds. A genuine passive fund tells you what it is and delivers what you’d expect – that doesn’t make it a lesser beast.

Perhaps the biggest learning from this is that you need to be a sharp investor in every respect.

Really get to know what it is you’re buying. If you are choosing an active fund – how good is the manager? While past performance isn’t a guide to future returns, you can still check to see if they ever deliver what they promise.

Or you could let us do it.

At AES International we lift the bonnet on a wide selection of funds and produce a White List of those we recommend. You won’t find any closet trackers on there.

Best of all, we negotiate discounts with all the fund managers. This means – even if do decide to pay more for the expertise of an active manager – you won’t be paying the full amount.

About Simon Danaher

Simon Danaher previously worked for AES International, in marketing and communications.