Pull Closet Indexing Out of the Closet?

John Authers of the Financial Times reports, Pull closet indexing out of the closet:
In the UK, people are trying to pull closet indexing out of the closet. It is a fight that could have global implications.

This is one issue on which there is no need to sit on the fence. The debate between active managers, who try to beat their benchmark, and passive managers, who merely track it, will go on and on. But everyone can agree that there is no case for closet indexing – the practice of running an “active” fund, charging active management fees but, in practice, offering an investment that merely hugs the index.

This is, in effect, a tax on millions of investors, for no economic benefit and helps pump up asset bubbles. It impedes capitalism and the efficient allocation of capital.

Closet indexing has been a problem for many years but it has moved to the top of the UK agenda thanks to a report published last month by SCM Private, a London-based investment adviser, which described closet indexation as “a UK epidemic”. After analysing £120bn in UK funds, it alleged that investors could have saved £1.86bn in fees if they had switched from underperforming UK equity funds to alternative cheaper index funds.

SCM Private emotively accused the UK fund industry of “systematic abuse of the public” and alleged that it had failed to behave with integrity. This is strong language, so let us look at the charges in detail.

Closet indexing has been well explored in academia. It is measured by “active share”, a concept invented by the Yale academics Antti Petajisto and Martijn Cremers. For US funds benchmarked to the S&P 500, it measures the fraction of a fund’s holdings that differ from the S&P. For example, if a fund’s holdings are identical to the index, except that it holds no shares in Apple (worth 5 per cent of the index) and has invested that money elsewhere, it will have an active share of 5 per cent.

A passive index tracker has no active share. A fund that invests only in obscure stocks not in the benchmark has an active share of 100 per cent. Once active share drops below 60 per cent, the academics said, a fund is a possible “closet indexer”.

SCM Private found that only 24 per cent of 127 UK funds benchmarked to the FTSE-All Share index had an active share above 70 per cent. This compares with 65 per cent of a sample of US funds that had an active share this high.

Overall, the UK funds had an active share of 60 per cent, compared with 75 per cent in the US.

The chances are tiny that a few tweaks to the index would do well enough to overcome the extra fees that active managers charge, which are on average three times the fees charged by trackers. And indeed 88 per cent of funds with an active share under 50 per cent did not match their index.

Why does this happen? The problem derives from the incentives for fund managers who are paid not to beat the market but to accumulate assets. This is because they charge a percentage fee on assets under management and are judged by comparison to their benchmark index and to their peers. To hold on to assets, therefore, it is vital not to underperform their peers. Make a big contrarian bet and you may be separated from the herd. So everyone herds into the same stocks.

As passive investing through index trackers has taken hold, active managers have grown more conscious of their benchmark index. This is clear from the language they use. Two decades ago, a portfolio manager would say he “owned” a stock. Now he is more likely to say he is “overweight” it, always implicitly comparing with the index.

This phenomenon helps create investment bubbles, as overvaluations naturally occur when everyone invests in the same thing.

It also creates opportunities for those who have the courage to search for them. SCM Private found that 72 per cent of the UK funds with a high active share succeeded in beating their index. This is in line with international research. The Cremers and Petajisto research found that in the US, funds with the highest active share beat the index by more than 1 per cent per year, even after taking their fees into account.

The UK is not alone. Research led by Mr Cremers looked at 21,684 funds in 30 countries, managing some $10tn as of December 2007. Closet indexing was dominant in some countries, accounting for 40 per cent of equity funds in Canada, and 81 per cent in Poland.

It also found that countries with the most explicit indexing were also likely to have less closet indexing, while active funds there would charge lower fees. Passive trackers provided stiff discipline for the rest of the sector. It also found that most active funds fail to beat their benchmark – but that the more genuinely “active” a fund, the more likely it was to outperform.

Fixing the problem needs a radical overhaul of the way fund managers are paid. For now, funds must be forced to publish their active share. Before being flushed down the toilet, closet indexing must be pulled out of the closet.
I encourage you to take the time to read SCM's full report, Closet Indexation: A UK Epidemic. Among the key research findings:
  • In a typical UK equity fund, investors can expect 40% of the portfolio to be a clone of the index compared to 25% in the US. These funds’ fees are often at three times the fees of a typical index fund.
  • Nearly half the UK equity funds analysed - 46%, were found to be ‘closet indexers’ 2 versus 10% in the US.
  • The cost in fees to investors of the under-performing UK equity closet index-tracking funds is estimated at £1.9 billion over the last five years alone. If this was to be deemed mis-selling, the liability could potentially be c. £3 billion across all equity retail funds within the UK.
  • The vast majority, 88%, of the funds in which most of the fund was found to clone the index (i.e. active share under 50%), under-performed over the last five years.
  • Applying a typical Annual Management Charge (AMC) of 1.5% to the part of the fund actually different to the market, suggests investors are really paying nearly 4% per annum for the active part of their investments.
  • The research findings give significant concerns that the UK investment industry may be breaching two of the FCA overriding principles that firms must ‘conduct their business with integrity, and
  • communicate information in a way that is clear, fair and not misleading’.
  • Only a quarter, 24%, of the UK funds analysed were radically different to the index assumed to be a 70%+ active share) as compared to 65% of US funds.
  • UK fund management companies are currently nine years behind US peers in providing quarterly full disclosure of holdings online. Since 2004 the US Securities and Exchange Commission (SEC) has demanded all funds to provide 100% portfolio disclosure quarterly.
Of course, the UK's Investment Management Association wasted no time rejecting these claims:
Daniel Godfrey, chief executive of the IMA, the UK fund industry trade body, says that SCM presented “no evidence” of mis-selling or any breach of the Financial Conduct Authority’s principles.

“The SCM report is sensationalist, offering massive assertions as fact, particularly on mis-selling. It presents no evidence.”

SCM looked at 127 funds within the IMA’s UK equity income and UK all companies sectors that had a five-year record and managed a minimum of £100m. It found that almost half (46 per cent) were “closet indexers”, with 40 per cent or more of their holdings matching the underlying index.

Mr Godfrey says SCM was selective in excluding funds with assets of less than £100m and had ignored a substantial portion of those two UK equity funds sectors.

He adds that retail clients make up a large proportion of UK equity funds with less than £100m in assets, as these funds were often too small to attract large institutional investors.

The IMA’s UK equity income and UK all companies sectors have 367 constituents and manage a total of £201.5bn. SCM’s sample had assets of £120bn.

Mr Godfrey says there could be a small number of funds that do little but hug the index and that the IMA would welcome any such examples being exposed.

But he emphasises that a more detailed analysis is required to establish whether a fund is hugging an index continually and to determine what a manager is doing with that part of the portfolio that is being actively managed.

“Investors should question managers and ask them to explain their strategy. An active manager could hold a neutral view on a large number of stocks in the portfolio. But if even the active part of the portfolio aims to only modestly outperform its benchmark, then it is not worth a full active fee,” says Mr Godfrey.

The Halifax UK Growth fund, the clearest example of an index clone within SCM’s analysis, provided an annualised total return of 6 per cent over the five years to August 2013, compared with 7.4 per cent for the FTSE All-Share.

Scottish Widows Investment Partnership, which runs the Halifax UK Growth fund, says the product is “not a passive tracker”.

“This fund is managed to a strategy that involves a broad range of stocks, rather than a small number of large positions. Inevitably this management style produces a greater overlap with the index,” says Scottish Widows.

The IMA also questioned SCM’s call for UK managers to make quarterly disclosures of their fund holdings, as has been the US practice since 2004. Index hugging by US equity managers appears to have declined since 2004 and stands at just 10 per cent, according to SCM’s analysis of 227 mutual funds.

Mr Godfrey says UK equity funds already disclosed their holdings twice a year in their interim and annual shareholder reports. A move to quarterly reporting would not be “transformational” for transparency as claimed by SCM.

“I very much doubt that index cloning as described by SCM is a significant problem in the UK equity funds sector,” says Mr Godfrey.

However, Andrew Clare, professor of asset management at Cass Business School, believes index hugging is a significant issue for UK equity funds, particularly those aimed at retail investors.

“Many institutional investors now use low cost passive funds in combination with high alpha [active] funds, but it is much more problematic for retail investors, who often lack the information to know what they are buying,” says Prof Clare.
There is no doubt that index hugging is a widespread problem in the UK which is why their regulators are now being urged to investigate these claims. And this isn't only a UK problem. As John Authers notes in his article, closet indexing was dominant in some countries, accounting for 40 per cent of equity funds in Canada, and 81 per cent in Poland.

This issue lies at the heart of why I believe well-governed defined-benefit plans are much better than defined-contribution plans. The alignment of interests are all wrong in most DC plans. These index huggers are the worst offenders, incentivized to gather assets, not to deliver performance.

Importantly, the fact that billions in fees are doled out annually to funds that hug an index and underperform low cost index funds is nothing short of scandalous. It's a testament to the failure of our society to educate people on how to properly invest their money and make sure they're not being robbed blind by funds gorging on them with slick marketing presentations and television ads.

I've been critical on hedge funds, exposing myths in the industry, arguing that in many cases fees are outrageous and should be chopped in half.  This is especially true of some big hedge funds that have become large asset gatherers, often underperforming their smaller peers struggling to survive.

But at least hedge fund managers have significant skin in the game (or at least they should!!!) and their alignment of interests are with their clients. This why the very best managers are not scared to deviate from the crowd, making significant investments in things that others are too scared to touch.

When I read that John Paulson and 'a clutch of bullish US hedge funds' are leading a charge into Greek banks, I chuckle thinking back to my May 2012 comment looking beyond Grexit. I can say the same about my calls on the solar boom and the age of biotech. I was way too early but if you look at solars (TAN) and biotech shares (IBB), you'll see  incredible outperformance over the past year (and the ETFs hide truly spectacular returns of individual companies...just ask the Baker Brothers. But be careful with these solar and biotech shares as they are vulnerable to a major 'high beta' correction!).

Of course, it takes courage to make contrarian bets and most of the time you'll get your head handed to you. Timing is crucial but my point is smart fund managers are not looking at what the herd is doing, they're always looking 18 to 24 months ahead and not afraid to make big bets on distressed securities if they have conviction (like buying Greek bonds when everyone else is worried about the end of the world).

When I wrote on the Paulson Disadvantage Minus Fund, I stated:
As far as investors who are increasingly frustrated and looking to redeem from Paulson now, it's very late in the game. The time to have redeemed from Paulson was after his "stellar year," less so now. These funds of funds managing high net worth money are ridiculous, covering their asses because they were unable to determine the return drivers in Paulson's fund beforehand and protect their clients' gains. 
It never ceases to amaze me how stupid, lazy and utterly incompetent some people are when investing in external fund managers. Maybe they are following the advice of their useless investment consultants but that is no excuse for making poor investment decisions at the worst possible time.

Let me be blunt. There are too many investors, including many in Pensionland, who are practicing CYA politics and neglecting their fiduciary duty. They fly all over the world, wine and dine with hedge fund managers and attend useless industry conferences. But what they really should be doing is sitting down with portfolio managers, analyzing their holdings in detail, gauging whether they're taking appropriate risks and delivering real alpha, not camouflaged beta. They should be asking tough questions and thinking ahead, not behind.

I've gone head to head with the Ray Dalios and Andreas Halvorsens of this world. I've met industry titans and grilled them just as hard as I grilled less well-known managers. No doubt, my direct style may have irked some managers but I'm sure most of them enjoyed the exchanges and tough questions. And some of them put me in my place, reminding me it's much tougher managing money than allocating to external managers (Back in 2004, Dalio blurted "son, what's your track record?" when I pressed him on why I thought deflation was a bigger threat than inflation. Gordon Fyfe, president of PSP Investments, got a real kick out of Dalio's response and kept bugging me all day. I felt like Homer Simpson, DOH!!!).

The point I'm making is that investing in external managers isn't as easy as you think, especially when dealing with well-known hedge funds. Sometimes you have to make tough decisions and redeem when everyone is plowing into a fund and other times you have to invest in a fund when everyone else is redeeming. But you always have to ask tough questions to every manager regardless of their recent performance. 

As far as charging high fees for closet indexing, it's simply unacceptable and should be a criminal offense. Maybe that's why it's more rampant in the UK and Canada than in the United States. In the U.S., active fund managers are scared of being sued for charging excessive fees if they hug an index, and rightfully so. In the UK and Canada, it's just business as usual (retail investors need a reality check on pensions).

Following my comment on whether investment consultants are useless, Ron Surz of PPCA sent me his white paper, Hiring a Portfolio Manager is Like Hiring a Professional Gambler: Mind Your Ps and Qs. Ron also sent me a couple of clips which I embedded below, including one peering into the future of hedge fund evaluation.