It is encouraging to see the FCA close in on lazy fund management, but more needs to be done
Without fanfare, the FCA has confirmed its intention to punish lazy fund management. Several groups have been persuaded into voluntarily compensating investors who bought their beta-posing-as-alpha products, otherwise known as closet trackers.
The regulator suggests that more than £140bn might be in funds that exhibited a low monthly tracking error relative to the Morningstar category benchmark, with around 75 per cent of that exhibiting a clean fee of more than 50 basis points. I think that is an underestimate.
One can argue about the FCA’s definitions of what measure defines fund management activity – and what benchmarks for that matter – but where businesses profess to offer what is understood to be active management and do not, it is at best an unfair commercial practice and at worst tantamount to fraud.
But a precursor to transparency is a definition of what active management really means and how to measure it. This allows a sensible assessment of value for money – price relative to investment selectivity.
Active management need not be about trading but it is certainly about selectivity. If a manager attempts to mirror an index, they make no selections. But what if they mirror all the stocks but weight slightly in favour of some versus others? Is this “a bit” active?
These are what the regulator terms “closet-constrained” funds. They are often marketed as defensive funds, but frankly they are a cop-out. By limiting positions versus the market, in reality the manager is more interested in keeping a job. To paraphrase Galbraith, no one fears failing conventionally. That approach should command a fee little higher than prevailing passive rates.
What we should be looking at is the degree to which a fund is active, versus the associated cost, and the outcome – excess or shortfall. We should also recognise that selectivity may be a better description than activity for non-passive investment styles.
A measure of selectivity is the degree to which selections are not representative of the sample. The more selective the manager, the less the portfolio looks like the sample being selected from. If a manager purports to be selective and charges a premium for doing so, then I might expect the price of selectivity to rise as my fund is increasingly different from the pool of stocks I select from.
A useful measure of selectivity is active share (the degree to which a fund’s holdings differ from those in its benchmark). It is calculated by taking the sum of the absolute value of the differences in the weight of each holding in the fund, versus the weight of each holding in the benchmark index and dividing by two. The higher the active share (maximum 100) the more active the management.
However, high active share does not guarantee outperformance. It only promises a degree of different performance. The manager might be highly selective but rubbish at it. That is the risk you take paying a premium price for selectivity.
To counter this, a fund’s active share can be compared with its tracking error (the standard deviation of the difference between the returns of an investment and its benchmark). Higher active share (above 60 per cent) and around sector median tracking error (the median of the fund sector) suggests higher selectivity – but also diversification – in the portfolio.
In our July Gatekeeper Report, we found that over the longer term active UK equity funds that consistently underperformed the index had an average active share of less than 60 per cent – the level below which a fund is deemed to be a closet tracker.
Of those funds that beat the index, the average active share was 70 per cent, demonstrating that performance alone is a shallow measure of the efficacy of active management.
We found that index trackers are where you would expect them to
be: active share in single figures and a low tracking error. These accounted for around 11 per cent of the funds in our list. At the high end of the active share scale, focused funds that adopted concentrated stock-picking had an above-average tracking error as one might expect. These funds were in the minority, representing around 7 per cent of the sample.
However, we did find funds exhibiting low tracking error with low active share, clearly priced as active funds but behaving very much like the index. These are the closet trackers, accounting for almost one third of UK equity funds – a higher figure than the FCA estimates.
We also found a cohort with high active share but low-to-median tracking error. These funds tended to have significantly larger numbers of stocks in them; broadly diversified while still exhibiting high selectivity.
They accounted for roughly half the funds in the sample. When closet trackers and index funds were removed for the performance calculations, average alpha of the sample rose significantly. Collectively, the minority of funds that are closet trackers average down the performance of active management per se.
The FCA’s campaign against closet trackers should be supported by managers who are proud of their stock selection capabilities. If active management is to hold its head up as a valuable service to investors, it has to be vocal in its intolerance of closet tracking.
Graham Bentley is managing director of gbi2