Organisation Better Finance, a representative body for European individual investors, have raised the issue of ” closet index trackers” and their fund management charges. It is suggested that many funds who pretend to be “active” in nature (as opposed to simple index trackers or passive funds) are not in reality because they hold very much the same stocks as index funds. This means that their performance is very similar to index funds. However, they charge management fees that are more like those of active funds than passive index funds, for example 1.5% to 2.5% whereas passive funds can be below 1%.
The management charges have a big impact on the overall return from investment funds over the long term. Research suggests that active funds can outperform index funds, but only if they are really active in nature. In the case of closet index trackers, investors may be paying for activity and performance that is not achieved.
The European Securities and Markets Authority are looking into the issue. The UK’s Financial Services Consumer Panel has suggested to the FCA that funds be required to state how closely their portfolios match their benchmark index – for example a percentage of how many of their holdings match those of the index.
Comment: retail investors certainly need to be aware of this issue when looking at the performance and costs of funds. Too often investors are sold funds as being active stock pickers or following “bottom-up” investment strategies when in reality the manager is hugging the index because diverging significantly is more risky. But without accepting more risk, returns are not likely to be superior.