Charging the same fees for active funds that hug the index as for genuinely-active funds is increasingly being presented as fraudulent or mis-selling – as something inconsistent with the duties of care owed to customers by fund providers and by advisers recommending funds. An example is today’s FTfm article titled ‘Regulators must tackle closet-tracking ‘epidemic’. That’s a pretty damning observation about something that is clearly very technical. Can we be sure that technical analysis really supports it? Well, yes, actually. But unfortunately it doesn’t support the corollary: that the genuinely-active funds are selling a better proposition.
Rather than get hung up on whether benchmark hugging is a false prospectus inviting regulatory intervention (there’s a lot of self-promotion and vested interests on both sides of that argument) it might be sensible to focus instead on the inherent paradoxes in any approach to active management. I hope the FCA, which has stirred up this debate in its ongoing review of the asset management industry, is also mindful of these.
Other than about degrees of difference, there is little disagreement about what closet index funds are. They are those whose holdings, and weights in each, are close to the constituents of the index they are measured against. They take small bets off the index or have (more technically) a low ‘active share’. The economic and ethical arguments against low active-share funds are one and the same: the proposition is self-defeating because the bets are too small to overcome the cost hurdle. It’s not that the proposition is false or mis-sold because the fund will provide the same outcomes as an index-tracking fund at higher cost. After all, there are many different active-management approaches that converge on the market return adjusted for expenses, not just those with a low active share.
So let’s stay with the idea the proposition of a low active-share fund is self-defeating and only a high active-share fund is taking large enough bets off the index constituents (holdings and weights) to cover costs. That has only ever been an argument about costs because the confidence in the outcomes before costs is not the same. Taking small, frequent bets off an index reduces the time required ( ie the number of data observations) to be confident that the achieved relative performance was not just the product of chance. (This is also the appeal of what are variously known as ’tilted’ index, ‘smart beta’ or ‘intelligent’ index funds – though they aim to get over the economic paradox by charging lower fees than closet index funds, reflecting the fact that they can be managed mechanistically.) The bigger the bets off the index, the more likely over the same period that the result was explained by chance, to the extent that the period required for an equivalently-high level of confidence about a manager’s skill could be longer than their tenure as manager of the fund! That confidence difference clearly matters.
Likewise, the larger the bets, the greater the likelihood that a manager who (with the benefit of hindsight) is a ‘star’ will, somewhere along the way, have looked indistinguishable from a ‘dog’. That just creates a different selection problem: it’s harder to live with your original choice. Investors’ errors in reacting to the path of a fund’s relative performance can also make a preference for high active-share funds self-defeating.
A further paradox is often overlooked. Most investors who choose active funds diversify the active-manager risk inherent both in their original selection and in their reselection choices by holding many funds rather than just one. But even choosing only high active-share funds in the mix will lead to index hugging unless they all hold the same strategies. They then become their own closet indexer.
Clearly there are many ways the active-management proposition can be self-defeating, not just by hugging the index and charging too much.