Question: What’s worse than putting your money into an active fund that charges high fees?

Answer: Putting your money into an active fund that charges high fees, but that to a large extent holds the same shares as its benchmark index.

Such funds are known as closet indexers, and a new report by wealth manager SCM Private claims that the UK is amok with these clone funds, compared to both the US and to investor expectations.

SCM’s research found 40% of the holdings of the average UK fund matched the underlying index, versus 25% in the US:

Attack of the clones.

Attack of the clones: The typical UK active fund is 40% an index tracker.

It says that nearly half of UK equity funds fall into this closet indexing category, compared to just 10% in the US:

New research has clone index funds coming out of the closet.

SCM’s research brings clone indexers out of the closet.

Now given that most active funds fail to beat the market, you might cynically think the more of them who copy the index, the better.

But closet indexing is a poor deal for many reasons.

Firstly, if your fund largely mirrors an index, you’ve got even less chance of beating it.1

True, we have abundant evidence that the majority of active funds will fail to beat the market long-term, anyway. But closet indexers are even less likely to outperform. Presumably if you’re putting money into an active fund then that’s what you’re trying to do – so you want to pick a fund with the best shot at doing so.

Secondly, you’re paying a lot of money for less active management than you thought you were getting.

If you’re paying, say, a 2% management fee to a fund manager, but half of the fund is effectively an index tracker, that means at least 1.5% of your fee is effectively paying for the actively managed portion of the fund – which means you’re actually paying 3% for their active efforts! That’s a very high hurdle for their picks to get over every year before they can beat a cheap index tracker.

Thirdly, SCM says there may be miss-selling implications.

I think this is a stretch – if fund managers are allowed to implore you to put your money with them to beat the market even though so few do, it seems anything goes – but in the post-PPI climate, maybe they’re onto something.

Why do closet index trackers exist?

As you might have guessed from my pretty mild outrage, I’m not particularly aghast to learn that so many UK funds are closet index funds.

Perhaps that’s because I’ve known about the tendency for while, or maybe it’s because after so many years of financial scandal and drama, this one seems a village green sort of scam – more Bertie Wooster than Bernie Madoff.

SCM’s boffins worked out that under-performing closet index funds have cost investors £1.9 billion in fees in the past five years, which is admittedly quite a sum. And I do have sympathy for newbies to investing, to whom index tracking seems utterly illogical, whereas paying an expert to manage their money seems most prudent. They are being sold a pup.

But the great mass of the closet indexing money will be in the hands of experienced investors who’ve had plenty of time to wise up. Monevator alone has been making the case for cheap tracker funds for six or seven years!

Indeed, a big reason closet indexing exists is due to the unreasonable demands of investors.

I’m not defending the financial services industry, but it’s worth noting:

Investors are unrealistic. They want market beating funds, but they don’t buy into funds that have had a bad year. Perhaps they even pull their money out of them. This means under-performing the index – even for a short time – is a big risk for the typical fund.

Now beating the market over the long-term is extremely hard, but beating the market every year is impossible. Not even Warren Buffett has done that – he has lagged the index plenty of times. The odd losing year is the minimum price of trying to beat the market.

Of course the fund management industry encourages us to believe otherwise – provided we invest with their people who work harder, smarter, later, or more photogenically. So no tears for the industry. But it does explain closet indexing to a large degree.

Fund management companies have little incentive to risk failure. For massive firms it makes much more sense to try to keep investors broadly content in order to collect those hefty fees, than it does to try to shoot the lights out and risk an exodus of money if you fail.

Career risk is another reason for closet indexing. Even if a fund provider wants its managers to really try to beat the index, it will probably fire someone who lags the market by 5% quicker than someone who lags it by 2%, let alone a manager who delivers 1% either side for a few years. If you’re a well-paid fund manager, wouldn’t you play safe?

The rise of computers and modelling has made it simple to determine variables such as tracking error. This data may be used by sophisticated investment committees and trustees to determine where their money goes. A fund naturally wants its numbers to look good.

Finally, active managers aren’t stupid. On the contrary, they are smart. They have read the same stuff you and I have read about the difficulty of beating the market, and while they may have some behavioural quirks that allow them to feel they’re special, they’re not utterly deluded.

The fear that they are being asked to do the impossible must gnaw away at fund managers sometimes.

Do they really dare shun HSBC, when it makes up nearly 10% of the index? Do they dare ditch BP, or GlaxoSmithKline? Look at all the controversy Neil Woodford has gotten into for refusing to hold oil companies in his much-lauded income fund – and he’s a deity among UK investors.

Can you imagine a 28-year old fund manager in a big institution who is managing a large cap UK fund being able to justify an eclectic pick-and-mix approach to the FTSE 350? Maybe avoiding all banks and oil companies, but going heavy on smaller industrial firms? And justifying it not just to her own boss, but to repeated rounds of big investors?

They’ll say it can happen, but the evidence suggests otherwise.

Don’t be a clone drone

The bottom line is if you want a shot at returns from funds that are sustainably different from the index, you will need to dig deeper into each fund’s holdings to see what it’s invested in.

In an ideal world, funds would clearly publish their active share in the fund literature, so you could identify a closet indexer at a glance. But for now you’ll need to check with sites like Morningstar, or else work it out for yourself.

Of course the bottom BOTTOM line is you shouldn’t go down this road at all. Investing passively into tracker funds is simpler, cheaper, and more likely to deliver better returns over the long-term.

  1. See H K.J. Martijn Cremers and Antti Petajisto of the Yale School of Management’s working paper: How Active Is Your Fund Manager? A New Measure That Predicts Performance.

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