Two recent reports show that active fund managers are effectively taking the Mickey out of advisers and investors. Closet indexing is nothing new but what a recent report by SCM Private shows is that it’s a lot more widespread that earlier thought.
The report shows that about 40% of an average UK actively managed fund are simply a replica of the same index they are trying to beat. What’s more interesting is that only 30% of UK equity managers are remarkably different from the same index they are actually tracking.
To my mind, it reveals the lack of integrity and conviction among many fund managers. I think every adviser should ask the questions ‘why should I trust these people with my clients’ money?‘
This may also explain the underperformance among so many active managers. A fund with a high active share – (‘active share’ being the term used to describe the proportion of holding that is very different than the index) is far more likely to out performance than one simply hugging the index. The research shows that nearly 9 out of 10 closet indexers in the UK equity sector fall to beat the FTSE All in the 5-year period up to August 2013 compared to 28% of funds with 50 or more active share.
In effect, these closet index huggers are charging active fee for a performance that is worse than if you simply buy a passive fund. Add this to a recent report by Morningstar, which shows that when it came to fees and expenses, the UK fund industry ranks behind India, China & Thailand.
But here’s a really good question; why do active managers hug the index? Well, it turns out it’s in their interest to do so. In the end, fund managers (like everyone else) want to preserve their own income and careers, even at the expense of investors.
Investors rarely penalise a manager if they underperform the index in rising markets. On the contrary, managers who underperform significantly in a down market get severely punished because investors are more likely to feel the pain of loss and subsequently leave. Therefore, managers can’t really go wrong with index-hugging. In a rising market, index huggers can claim the glory, even if they underperform slightly. In a down market, they can blame the market! That way, they can eat their cake and have it!
I’m no betting man but if a fund manager is hugging the index, you can probably place a good bet on their chances of underperforming. The problem for advisers and investors is that there are far too many index hu and it is near on impossible to specifically identify index huggers as UK fund managers only disclose their holdings once a year. My advice is, if in doubt, buy trackers!