• Stuart Fowler

Closet trackers: FCA wades in

In a new report, the FCA says it is not happy with the way some fund managers are describing their investment approach relative to their benchmark index. Its concern is from the Conduct of Business standpoint of disclosure not being complete, fair and not misleading. It does not specifically address the ‘value’ aspect of a false prospectus: that investors may be paying for active management but getting passive results.

It is this value aspect which most exercises opponents of closet indexers, whether they come from the ranks of active managers (who feel they themselves are genuinely active and that ‘closet indexers’ are giving them all a bad name), passive managers (who welcome the bad name given to active management generally) or consumer advocates (who generally think that the fund management industry is selling a dodgy product).

The FCA report is based on too small a sample to be anything other than an alert to a possible problem: 23 funds from 19 firms. Bizarrely it also reviewed 4 segregated (i.e. having a single client) institutional mandates – too few to be meaningful but enough possibly to interfere with the conclusions of its retail-fund analysis. It is not even clear whether they are all equity funds where a benchmark index can be expected to explain much of the manager’s return, whatever their approach (i.e. whether it excludes funds with composite indices, made up of more than one market or more than one asset class, either drifting with returns or rebalanced to fixed weights).

The FCA finds fault with 7 instances out of 23 (or is that 27?) but it is not easy to deduce how many of the shortcomings are egregious (though offenders evidently include some funds that are not being actively marketed) rather than nuanced.

The regulator refers to closet indexing but only to acknowledge a term widely used by others. It does not tell us what data analysis techniques it used (referring only to ‘desk research’) nor does it define in statistical terms what it regards as risk and return objectives effectively equivalent to an index fund and which might therefore, without adequate disclosure, constitute a closet indexer. It is only concerned with the quality of information given to investors that might allow them to form realistic expectations of future performance. Hence the COBS terms of reference.

I very much doubt the FCA nowadays has the overarching intellectual framework to see the irony of its analysis and its conclusions in this case. This contrasts with the calibre of its thinking about active management issues at the time, for instance, of depolarisation and the Sandler Review. But that got it into a lot of trouble, needless to say, with active managers.

The first point it appears to have missed is that comprehensive data analysis of the performance of open-ended single-market equity funds domiciled in the UK shows that there is limited predictive information contained in the way managers describe their approach to the size of bets off the index.

This is true even of single-market equity funds. The data throws up a mismatch between the consistency of a managers stated approach and the inconsistency of the actual results. You might argue that the ability of the index to explain fund return variance (R Squared) and fund beta (variance relative to the index variance) are inconveniently unstable over time because managers are not in fact consistent in sticking to a single approach. More likely, however, is that the instability is inherent in the risk and return structure of equity markets and managers are powerless to control this power, which is probably largely random in nature. That is why what the manager says about its approach to relative return and relative risk is likely to be misleading unless it admits to its own powerlessness. In fact, the only reference actively-managed public funds make to anything resembling powerlessness or randomness is the statement, prescribed by the FCA for all funds, that past performance is not indicative of future performance. That would imply that neither is the stated manager approach to risk and return.

The second point that the FCA appears to have missed is that the problem of unrealistic expectations manifests itself for investors not so much at the level of individual funds but rather of combinations of funds, because most investors (whether advised or self-directed) hold many not one. They are effectively diversifying the active-manager risk. Critics of active management should be arguing that it is irrelevant whether some managers can deliver a fair outcome (achieving the target outperformance after active fees) if the effect of diversifying the fund exposure is that the investor is likely on average and over time to earn index returns but pay active fees. They defeat their own objective.

In this case investors should not be looking to the FCA for improvements in actual outcomes via tougher rules or enforcement. Better outcomes require insights about their own behaviour as investors. When investors look to the industry for advice or delegate selection decisions, whether to IFAs, stockbrokers or wealth managers, they are entitled to expect to benefit from those professionals having these insights. Sadly, this is all too often not the case. It is the professionals who are most lacking in insight, most resistant to insights that appear to undermine their purpose in life or most cynical about selling a prospectus they know to be false.

The report does support investors who opt for a passive approach but mainly by what it unintentionally suggests about the fundamental nature of active management risk and reward.


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