MALTA: Circular on Self-Assessment in Relation to the Evaluation of Potential Closet Indexing Practices Adopted by UCITS and Retail AIFs

Wednesday July 11 2018

The MFSA has published a self-assessment in relation to the evaluation of potential closet indexing practices adopted by UCITS and Retail AIFs. The self-assessment applies to:

• Self-managed Undertakings for Collective Investment in Transferable Securities (‘UCITS’) licensed in Malta;
• Management Companies managing UCITS licensed in Malta;
• Self-managed Retail Alternative Investment Funds (‘Retail AIFs’) licensed in Malta;
• Maltese AIFMs managing Retail AIFs licensed in Malta (collectively referred to as “ManCos”)

Notwithstanding the first paragraph, any of the above-mentioned Funds which satisfies any ofthe following criteria:

• have NAV lower than EUR 10 000 000, or
• are charged Investment Management Fee lower than 0.8% of the Fund’s NAV, or
• have already disclosed in the Offering Documentation the tracking of a benchmark, including but not limited to, volatility returns, geographical focus, i.e. approved index tracking Funds shall be excluded from the scope ofthis self-assessment.

The concept of Closet Indexing

Indexing, in general, refers to the practice of Fund Managers claiming to manage portfolios actively when in reality the Fund composition is close to a benchmark, whilst closet indexing related to indexing without appropriate disclosing of this activity to investors. This may give rise to a situation where investors are not receiving the service or risk/return profile they expect based on the Fund’s Prospectus/Offering Documentation while potentially paying higher fees compared to those typically charged for passive management

As part of its supervisory work on ManCos, the MFSA is currently undertaking an exercise to determine the extent of potential closet indexing in Malta. In this regard, the MFSA requires ManCos to conduct a self-assessment on all Funds’ managed by them.

The methodology for a self-assessment

ManCos, as defined above, are being requested to carry out an exercise to determine whether each of the Fund under their management is potentially a closet indexer or index hugger. As an initial step, the ManCos should identify an appropriate financial index that more or less represents a reasonable universe of the potential securities the actively managed Fund is allowed to invest in as described in its investment objective compared to a benchmark. In terms of SLC 4.14(ii) of Part BlI of Investment Services Rules for Retail Collective Investment Schemes, a financial index shall fulfil the below:

• the index measures the performance of a representative group of underlyings in a relevant and appropriate way;
• the index is revised or rebalanced periodically to ensure that it continues to reflect the markets to which it refers following criteria which are publicly available; and
• the underlyings are sufficiently liquid which allows users to replicate the index.

For the sake of clarity, this benchmark should be the (standard) point of reference against which the performance of a given Investment can be measured. The chosen benchmark should reflect the strategy/ type of securities of the Fund as much as possible. An index tracks the performance of a broad asset class, such as all listed stocks, or a narrower portion ofthe market, such as technology company stocks, which are used as a benchmark for the Fund portfolio.

Assessment of the Fund

ManCos should determine whether a Fund falls under the below criteria classifying it as a potential closet indexer by considering: (a) “active share”, (b) “tracking error” and (c) “R2” (r-squared) as all-inclusive metrics, as a minimum.

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