Wednesday September 9 2020

News Source: Fund Regulation

Focus: Closet Trackers

Type: General

Country: UK

On 9th September 2020, ESMA published a Working Paper on Closet Indexing Indicators and Investor Outcomes. The study found that investors can expect lower net returns from closet indexers than from a genuinely actively managed fund portfolio.

The paper analyses the specific situation in which asset managers claim to manage their funds in an active manner while in fact tracking or staying close to a benchmark index. Such practices – often referred to as “closet indexing” – represent a form of misconduct on the part of the asset manager, which has been criticised by supervisors and investor advocacy groups on numerous occasions in recent years.

An economic incentive for closet indexing is that fees for funds with an active mandate tend to be higher than fees for passive funds, while the economic costs of passive management may be less than for active management, since staying close to a benchmark requires less input from the manager. While supervisory activities are ongoing to limit such practices, this paper seeks to contribute to the understanding of closet indexing in the EU by providing evidence on how closet indexing relates to the costs and performance of EU domiciled equity funds

The authors of the study looked at annual fund-level data for the period 2010 to 2018, finding that investors saw both lower expected returns and higher fees when they invest in closet indexers compared with active funds. Overall, the net performance of potential closet indexers was worse than the net performance of genuinely active funds, as the marginally lower fees of potential closet indexers are outweighed by reduced performance.

Closet indexing is a practice that has been criticised by supervisors and investor advocacy groups on numerous occasions in recent years, over concern that investors are being misled about a fund’s investment strategy and objective and are not receiving the service that they have paid for.

ESMA and NCAs have worked to identify potential closet indexers by examining metrics on fund composition and performance and by conducting follow-up detailed supervisory work on a fund-by-fund basis. ESMA recognises that such metrics, while imperfect screening tools, are a useful source of evidence to help direct supervisory focus.

In summary, the results of the study suggest that outcomes for investors in closet indexing funds are on average worse than outcomes for investors in genuinely active funds. Investors face lower expected returns from closet indexers than from what they are promised, namely an actively managed fund portfolio. In other words, in addition to representing a form of misconduct in its own right, closet indexing investors makes worse off ex-ante. Even though potential closet indexers are marginally cheaper than genuinely active funds, this difference is outweighed by reduced performance: potential closet indexers perform worse even when fees are taken into account. More generally, ESMA’s results provide strong confirmation of the concerns of supervisors and investor advocacy groups that investors in closet indexing funds face an unjustifiably high level of costs, far in excess of those for explicitly passive funds.

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