Trackers who are afraid to come out of the closet

Closet trackers simply mirror their benchmark, showing no tracking skills worth the fees these funds charge investors. Picture: Getty

Fund firms overcharging ordinary investors and pension savers with cash in so-called “closet trackers” are under growing pressure to come clean on their holdings.

Almost £60 billion of investments and pension savings lies in funds that levy active management fees but which do little more than replicate their benchmark index.

The practice has been allowed to continue unchecked for years, but as charges come under greater scrutiny closet trackers are now thought to be in the regulator’s firing line.

The typical “closet tracker” is a UK equity fund with annual charges of around 1.4 to 1.5 per cent that are in line with those levied for active management (where the investment decisions are made by the fund manager/s).

But many such funds are barely more active than trackers, which aim to mirror the performance of the index and charge an average of just 0.6 per cent. The rip-off is compounded by the drag effect of the high charge on closet trackers, which means they tend to produce returns inferior to those on genuine tracker funds.

Some of the biggest culprits are pension funds, which invest billions of pounds of workers’ retirement savings.

It has been estimated that around 30 per cent of the money invested in the main UK equity sectors is held in underperforming funds in which there is little active management.

But investors are paying annual charges averaging 1.43 per cent for those funds, according to research by Premier Asset Management. Genuine tracker funds, in contrast, charge an average of just 0.61 per cent.

The study found that funds with a “highly active share” – which deviate from their benchmark index by at least 80 per cent – outperform closet trackers by 2.9 per cent a year. It also revealed that the returns from closet trackers tend to fall short of those from actual trackers.

Research published last year by the True and Fair Campaign, analysing 127 UK equity funds with a total of £120 billion under management, said that 46 per cent were arguably closet trackers, where 40 per cent or more of the funds holding’s matched the composition of their benchmark index.

The Financial Services Consumer Panel highlighted the issue in a damning report published last month, calling for all costs to be disclosed and packaged in a single annual charge. By disclosing their active share, fund managers would be coming clean on the proportion of their trading that’s within the index they use as a benchmark.

Some have already committed to doing so, including Baillie Gifford.

The Edinburgh firm, which runs funds including the Scottish Mortgage and the Scottish American investment trusts, will from the start of 2015 include the active share of all its funds on its fact sheets. “It is important for investors who choose an active route over passive to know that their fund is actually doing something different from the index,” said James Budden, marketing director at Baillie Gifford.

Any fund with an active share of, say, 30 to 40 per cent should be viewed as a closet indexer and is therefore “probably not worth paying up for”, according to Budden.

“On the other hand a fund that is at the other end of the scale really does differ from the index and as such has the chance to outperform it depending on stock selection,” he said.

Part of the problem, according to one Scottish investment expert, is that too many fund managers are afraid to follow their convictions.

“Their unwillingness to look too different from their peer group, for fear of getting it wrong and being sacked, is the main reason that lots of actively managed funds look and perform like the index they are investing in,” said Barry O’Neill, investment director at Carbon Financial Partners.

That would be fine if investors weren’t paying – often handsomely – for the alleged skill of the active manager, he added.

“With actively managed funds the additional costs of paying for this, and the higher trading costs incurred when the manager changes his or her mind about what’s hot and what’s not, mean you are are likely to get less than return from the market,” said O’Neill.

“A tracker fund will do the same or probably better job for a fraction of the cost.”

Investors who want to improve their chances of beating the index should seek to identify the types of funds that have been shown to deliver above-expected returns over the long-term, according to O’Neill.

“Simply buying these and hanging on to them avoids the myriad of ‘me too’ closet trackers that serve no purpose other than to line the pockets of the managers and the fund management companies,” he said.