Tuesday February 28 2017

News Source: Fund Regulation

Focus: Closet Trackers

Type: General

Country: European Union

On 12 February 2017, Better Finance replicated the ESMA study on closet indexing and identified up to 165 equity “UCITS” funds that could potentially be closet indexers.

In their press release they stated that ESMA would not disclose the names of the funds it identified as “potential equity closet indexing funds” in its investigation results released in February 2016 leaving fund investors in the dark. Due to this, Better Finance decided to replicate the ESMA study as closely as possible and – using the same quantitative analysis performed by ESMA – to disclose the list of the sampled funds, including those that are potentially “closet indexers” according to ESMA, and also those funds – more numerous – that ESMA did sample but did not analyse for lack of data.

Replicating in December 2016 the ESMA study performed in 2015, Better Finance could sample 2,332 UCITS equity funds using ESMA’s sampling criteria.

Better Finance broke them down into four categories:

  • 6% (147 funds) do not report any benchmark in their prospectuses according to Morningstar, making it impossible to provide the metrics used by ESMA to identify potentially falsely active funds, i.e. “active” share”, “tracking error” and “R squared” (see annex 3 for definitions). For example, 5.7% of Luxembourg domiciled funds do not mention any benchmark, 12.2% in Ireland, 1.5% in the UK and 5.3% in France.
  • 50% (1,172 funds) do report a benchmark but apparently do not provide enough information for Morningstar to compute the metrics selected by ESMA for those funds. For example, 34.1% of Luxembourg-domiciled funds do report a benchmark but still do not disclose their active share, tracking error or R-squared in the Morningstar database, 36.1% in Ireland, 60.8% in the UK and 64.0% in France.

In all, 57% of UCITS equity funds escape scrutiny because of a lack of available information in Morningstar. Only a minority of all UCITS equity funds (43%) can be analysed using the ESMA methodology and source:

  • 36% (848 funds) of all funds are sufficiently transparent (regarding ESMA metrics in the Morningstar database) and – based on those metrics – do seem to be truly active.
  • Up to 7% of all funds and up to 16 % of sufficiently transparent funds (165 funds) show characteristics that flag them as being potential closet index funds according to ESMA (active share below 60% and tracking error below 4%); for example, 46.4% of those funds are domiciled in Luxembourg, 7.8 % in Ireland, 7.2% in the UK and 15.7% in France.

A complementing review of investor disclosure documents revealed that more than a third (34%; or 21 funds out of 62) of the funds with the highest potential of being closet indexers according to ESMA (active share below 50%, tracking error below 3% and R square above 0,95) do not disclose their benchmark’s performance alongside their own performance in their KIID. This does not seem to comply with EU Law and makes it impossible for retail fund investors to assess the relative performance of these funds vis-à-vis their benchmark.

Also a majority of those funds seem to have underperformed their benchmark over the last five years. Better Finance did not check their performance versus low cost index funds (such as ETFs) using the same index.

Better Finance has called upon the national regulators and upon the asset managers involved to provide clear reasons for charging “active” fees (from 0,75% to 3,00% per annum) to investors in these potentially falsely active funds (according to ESMA), instead of fees of between 0,05% and 0,30% typically charged for index ETF funds.

It also calls upon ESMA and national regulators to provide much more transparency on funds’ metrics and to expand their investigations to the majority of EU domiciled active equity funds, including those that were not analysed by ESMA:

  • the majority of active equity “UCITS” funds (not included in the ESMA study):
    • those which did not disclose a benchmark in their prospectuses (147 funds in our study),
    • and those which did disclose a benchmark, but for which Morningstar could not compute their “active share” and/or their tracking error (1,172 funds in our study);
  • and all the active equity “AIF” funds that are distributed to retail investors in the EU.

Click on the link above for further information.