‘Closet trackers’ challenged to justify higher fees

Closet tracker fund managers have been accused of hiding behind jargon and investor ignorance. Photograph: Getty Images

PRESSURE is growing on fund managers to come clean on what they do to justify the fees they charge amid claims that some are potentially “defrauding” investors.

More than a third of funds are “closet trackers” that do little more than track the index but charge “active” fees, according to the latest in a series of reports highlighting the lack of transparency in the fund management industry.

It came as the industry trade body, the Investment Association, published new proposals on how fund charges should be disclosed.

Calls have intensified over recent months for fund firms to disclose their total costs and clarify what exactly investment fees pay for. There’s also been greater scrutiny of the charges paid by investors and pension savers on funds that are promoted as actively managing their assets but which are effectively trackers (which aim to mirror the performance of the market).

So-called “closet trackers” are typically equity funds with annual charges of up to 1.5 per cent that are associated with active management (where the fund manager makes decisions with the aim of outperforming the market). Yet 36 per cent of UK active funds are “expensive copies” of tracker funds, according to new research by SCM Direct.

The drag effect of their active fees means that many “closet trackers” ultimately produce returns below those on actual tracker funds, which charge 0.6 per cent on average. Investors lost £800 million to closet trackers last year and £3 billion over the previous five years, SCM estimated.

Gina Miller, founder of SCM Direct and the True and Fair Campaign, called on the Serious Fraud Office to investigate the practice.

“The UK industry is more than ten years behind the US in giving consumers transparency of holdings, in full, via the internet. Similar transparency in the UK would quickly reveal the 36 per cent of UK funds potentially defrauding the public by pretending to be truly active and offering something different to cheaper index products.”

The research should be a “wake-up call” for an industry that for too long has been getting away with overcharging, said Derek Stewart, managing partner at Sam Wealth in Glasgow. He accused fund managers of hiding “behind jargon and investor ignorance”.

“The value in an active fund is when the fund manager makes tactical decisions to take advantage of market conditions. That’s what you are paying the extra for,” he said.

“Greater transparency  will allow investors to see if they are getting value for money.”

Some fund groups, including Neptune, Threadneedle and Edinburgh-based Baillie Gifford, have responded to demand for greater transparency by committing to publishing their “active share”. This is the figure that shows the extent to which a fund deviates from its benchmark index, with funds that do so by at least 80 per cent considered to have a highly active share. Funds with an active share of around 30 or 40 per cent can safely be considered closet indexers, experts say.

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The active share is a “useful and informative” metric, said Jason Broomer, head of investment at Square Mile.

“It would be relatively straightforward for an average investment professional to design a portfolio with a high active share. However, by adopting more active risk it does not necessarily follow that they will deliver superstar performance,” he pointed out.

“Indeed, any poor investment decisions may well become apparent to their clients more quickly.”

But while the active share promotes transparency and accountability it shouldn’t be used in isolation and is “certainly no investment panacea”, Broomer added.

Stewart agreed: “It’s a useful piece of information but shouldn’t be relied upon on its own. It could be slightly misleading when talking about the ‘implied cost on the active part’ as during the year the composition of the fund will change, including the active part.”

What investors really need to know is the total cost of investing, said Stewart, but this still isn’t available.

The debate over the disclosure of charges took another twist last week with new proposals from the Investment Association, the asset management industry trade body. It suggested that charges for fund management should be disclosed separately to transaction costs, which it said were “quite distinct from a charge paid to the manager”. It also said performance fees and initial charges should be disclosed separately to ongoing charges.

The Investment Association claimed its proposals would provide clarity over the fund management charges paid by investors.

However, it stopped short of the single-figure charge put forward last year by the Financial Services Consumer Panel, which said any additional expenses should be absorbed by the fund manager and not investors.

“The value of an investors fund is eroded by charges, so understanding how much you are being charged and being able to compare what you are getting for it is important,” said Stewart. “But it’s not just what you are being charged that should be the focus, it should be what your net return is and how much risk was taken to get it.”