Should investors avoid “closet tracker” investment funds?
Following the FCA’s recent order for the reimbursement of £34 million in management fees by funds that were essentially tracking an index, but charged fees similar to those for actively-managed funds, Investors Chronicle ran an article entitled: ‘How to avoid investing in a closet tracker’.
Although balanced, informative, and generally helpful, the article puts the onus on the investor when it comes to spotting closet trackers.
The trouble with this approach is that most retail investors are insufficiently informed, and few have the time, to apply the tests it recommends.
Furthermore, as the article’s author admits, the test measures themselves are prone to misinterpretation.
Investors Chronicle advocates a bottom-up approach, but the UK funds market comprises some 2,000 products claiming active management.
That is too large and varied a universe for the average investor to analyse effectively.
It is more efficient, and probably just as effective, to apply a top-down discipline, wherein the topmost parameter should not be returns, but risk.
Identify (and price) that correctly and the returns should follow.
Most managers cannot beat the index
For a long time, risk was synonymous with the performance of the markets and, especially, their volatility.
However, the 2000 ‘dot-com’ collapse, then the 2007-2008 global financial crisis (GFC), led to a crash in fund returns and the realisation that most managers cannot beat the index – at least, not consistently.
So, the risk embedded in a manager’s investing style became obvious or, as Warren Buffett noted: “Only when the tide goes out do you discover who’s been swimming naked.”
Since the GFC, quantitative easing has overridden fundamentals (earnings growth, balance sheets, interest rates, dividends, etc.) and markets have been buoyed by waves of central bank cash.
This overthrow of established investment parameters has left active fund managers floundering and has become a leading factor in the growth of passive investing, in which the manager’s style, and its attendant risks, has been bypassed in favour of investing in the index itself.
The table above tells the story. Of 2017’s top 10 funds, in terms of winning new business, five were trackers (all from BlackRock). But no trackers feature among the worst sellers.
It seems investors have assessed manager risk correctly.
They have also priced risk correctly, paying a typical 0.06% to 0.25% in annual management fees for low-risk tracker funds, compared with the usual 0.6% to 1.0% charged for riskier active vehicles.
The numbers may not seem significant but, added up over several years, they become a key factor in net returns, enabling investors almost to ignore the cost of holding trackers by comparison with their active equivalents.
So, how to avoid closet trackers?
Investors should use trackers to deliver low-cost beta (the market return), rather than buying funds that invest, supposedly actively, in the leading equities.
Such securities are generally index constituents, so funds that focus on them are more prone to delivering tracker-like returns but at much higher cost.
The best way to avoid closet trackers is not to hold such blue chip-focused funds at all, but buy true trackers instead.
Even if a tracker does not have ‘tracker’ or ‘index’ in its name, which is unusual, an annual fee below 0.3% identifies it plainly enough.
There is little need for the Investors Chronicle approach, applying esoteric mathematical tests to reveal active funds that are actually in the closet.
Their focus on leading shares and higher fees provides the necessary red flags, even if that also means occasionally avoiding genuinely active funds.
Is diversification the answer?
This all seems to suggest that investors should only buy tracker funds. But that ignores the biggest risk, which is the markets.
In the next panic, the trackers’ market-matching declines could be exacerbated by the cost of rebalancing their holdings as the composition of their benchmarks frequently adjusted to reflect market capitalisations that implode at differing rates.
Moreover, as in previous modern downturns, world market indices may fall in unison, thereby catching investors with all of their eggs in one basket.
The antidote is diversification.
Not all asset classes are affected equally by a major market event.
In the GFC, for example, bond investors saw values rise as equities crashed.
Similarly, despite their high fees and recent disappointing returns, hedge funds have provided some protection during market crises, although that sometimes meant smaller declines rather than actual gains.
Only some strategies, such as equity-long-short, justified their fees.
Much more impressive has been the crisis record of managed-futures traders, also known as commodity trading advisers, or CTAs.
Although long popular in the USA, these strategies, which trade worldwide index, equity, currency, bond, and commodity derivatives, have been gaining favour with UK investors, helped by the launch of several UCITS
(https://www.investopedia.com/terms/u/ucits.asp) versions over the past decade.
Much more impressive has been the crisis record of managed-futures traders, also known as commodity trading advisers, or CTAs.
Although long popular in the USA, these strategies, which trade worldwide index, equity, currency, bond, and commodity derivatives, have been gaining favour with UK investors, helped by the launch of several UCITS
(https://www.investopedia.com/terms/u/ucits.asp) versions over the past decade.
What most of these ‘alternative’ choices have in common is specialisation. The managers tend to be more focused than the industry giants.
Even where the big beasts offer such products, they are often managed by discrete teams with specialised expertise.
Be holistic
Closet tracking, which is mainly a feature of the most liquid markets, such as US and UK equities, is impossible or rare.
Investors should approach active and passive funds holistically, therefore, achieving the right exposure to the right assets in order to enhance reward for risk across the entire portfolio.
Returns are not assured, but fees are, so minimising them is crucial.
The safe – and cheapest – course is to allocate much of a portfolio to trackers from the leading managers, but use a substantial chunk to buy funds from smaller specialists with a consistent record of beating their benchmarks.
Paul Connolly
Paul Connolly has been a journalist for more than 20 years, as a reporter and editor for Argus Media, Reuters, The Times, Associated Newspapers and The Guardian. He has covered Islamic Finance for Reuters in the 1990s. Paul has since helped launch three newspapers, as well as reported from Tokyo, Los Angeles and Stockholm.
