SWEDEN: Consumer Protection on the Financial Market – Closet Index Funds Investigation

Thursday October 1 2015

Finansinspektionen (FI) have published a report on consumer protection on the financial market. In the report FI discuss the tightening of rules and measures against closet index funds.

Consumers must be able to rely on the products they purchase. However, FI has seen examples of this not always being the case. An example is closet index funds, i.e. funds that are described as being actively managed and for which consumers have paid for an active manager, but which follow an index in practice.

Saving in funds is one of the most common saving methods in Sweden today. This is largely because of saving in pension and insurance solutions. The absolute majority of the fund market consists of actively managed funds, i.e. funds for which the manager makes active decisions, although saving in index funds is on the rise. The aim of index funds is to reflect their benchmark indexes and as a rule they have a lower management fee than actively managed funds, since they do not require such extensive management efforts.

An important source of information for consumers who save in funds is the key investor information document of a fund, the layout of which is governed by the EU key investor information regulation18. The regulation sets out that consumers must have access to a key investor information document of no more than two pages with relevant information about the fund prior to investment. The key investor information document has been devised to ensure that consumers receive consistent, comparable information about different fund alternatives, and contains brief information about the fund’s objective, investment policy, risk, past performance and fees.

In order to investigate whether the key investor information documents of the funds provide accurate, clear and not-misleading information about the objective and investment policy of a fund, FI analysed a number of actively managed funds in an investigation. The provision of information was also studied based on how such funds invest in relation to their benchmark indexes. Furthermore, the investigation encompassed how the boards of the fund management companies work on monitoring and control of the fund’s general investment policy and investment strategies.

The investigation brought to light deficiencies in how the companies describe the objectives and investment policy of the funds. For example, there were cases of companies having internal objectives of very low tracking error, while at the same time the fund has been described as active to consumers. Low tracking error refers to limiting deviations in the value growth of the fund in relation to the performance of the fund’s benchmark index, which does not square with an actively managed fund. There are also deficiencies in how the boards of several companies monitored the funds’ management and strategy.

On the whole, this risks leading to consumers not getting what they pay for. The difference in price between an actively managed Sweden fund and an index fund is around one percentage point. While this difference might seem negligible, with the interest-on-interest effect, the difference will be substantial in long-term saving.

Fund investigation

FI’s fund investigation showed that, in a number of key investor information documents, companies chose to highlight in particular the fund’s management activity by describing the fund’s active investment strategy and analysis of individual companies. Some funds also have explicit targets to outperform benchmark indexes or the Stockholm stock exchange average. The historical investments of the funds imply in many cases that they have been relatively close to the index, and that such descriptions thus do not give a fair presentation and give rise to unrealistic expectations. Several companies consider that their investment process is not passive, and that the fund can thus be described as active. FI’s opinion, however, is that it ought to be possible to describe the activity of the funds in a more toned-down and accurate manner based on how the management is devised and how the fund usually correlates with the benchmark index.

FI has also noted that several companies have internal management targets that are not communicated to consumers. The objectives aim to limit the fund’s tracking error by setting limits to how much the fund’s performance may deviate from that of the benchmark index.

Consumers who choose an actively managed fund pay an extra fee for the manager to take a certain degree of tracking error in excess of the benchmark index. Hence, they pay for the possibility of higher return, with the risk of a poorer return. When companies, in their internal management targets, choose to limit the fund’s tracking error, the fund’s possibility of attaining excess return in relation to the market on which the fund invests is also limited. In many cases, such deviation targets are set so tightly that, over time, it must be considered that the fund clearly features indexed management. In such cases, the objectives are not consistent with the description of the fund’s activity and return target in the key investor information document, which describes active management with in-depth analysis of individual companies and a high total return that overshoots that of the market.

During the course of the investigation, FI also noted that the boards of several companies monitor the funds at a very aggregated level, and mainly as regards the funds’ results performance. According to FI’s regulations, it is the responsibility of the board, for each individual fund, to verify that fund assets are invested in accordance with the fund rules. Aggregated and more general monitoring can therefore not be considered appropriate.

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