The UK fund management industry closet indexing epidemic continues to be ignored by the regulator and condoned by industry trade bodies, according to new research by SCM Direct which found that the 10 worst offending UK funds cost investors £346m in terms of under-performance when compared with similar index funds during 2014 alone.
With no sign of action to eradicate this deception, which amounts to fraud, the British public should consider legal action against UK fund groups, according to Gina Miller (pictured), founding partner at SCM Private.
“We are campaigning about transparency of costs as this is a key factor alongside risk and return for investors to best judge and assess an investment,” said Miller. “Without those elements is difficult to make the best decision.”
SCM Private, said Miller, has filed its views on costs on consultations such as the Markets in Financial Instruments Directive (Mifid) and Packaged Retail Investment and insurance Products (Priips) but it is still concerned about the names used in funds.
“You can call your fund growth, aggressive or guaranteed but that doesn’t mean that’s what you are buying,” said Miller. “Some fund managers are saying that they’re actively managing a fund in the product prospectus but when you look under the bonnet they are copying the index. This is a terrible practice tantamount to fraud because they are pretending to do something when they doing something else.”
These issues are not new and come up in conversations with financial advisers because the costs of an UK equity fund are much higher than those of a tracker fund, said Gary Dale, head of intermediary sales at Investec, talking as a member of the executive committee of the UK Structured Products Association (UK SPA).
“We have seen a significant increase in the use of passive investments as a result of their flexibility and as a reflection of active managers struggling to beat their benchmarks,” said Dale. “These funds charge around 125bps but if you look at trackers such as our UK volatility fund, these charge 50bps and have outperformed their underlyings.”
The problem is that closet indexers are very expensive relative to what they offer, said Miller, as a closet indexer charges active management fees on all the assets in the mutual fund, even when some of the assets are simply invested in the benchmark index. “If a fund has an Active Share of 33%, this means that fund-level annual expenses of 1.5% amount to 4.5% as a fraction of the active positions of the fund,” she said. “Since only the active positions of the fund can possibly outperform the benchmark, in the long run it is very difficult for a closet indexer to overcome such fees and beat its index net of all expenses.”
According to the SCM Private research, more than a third of the UK funds (36%) are no more than “expensive copies” of index funds, a practice that rolled out across the retail industry could have cost investors £803m in 2014. The research also found that rather than the purported charge of c. 1.5 - 1.6% pa, the real cost of the genuinely active part of the fund was over 7% pa in the worst two cases; and that the average ‘implied’ annual management cost (AMC) of the active part of a UK equities fund was 2.5% pa on average rather than 1.5% pa.
In their hunt for alpha, said Dale, active managers have higher volatility and higher charges. “It is a question of strategy and perhaps these managers should be a bit more pragmatic on what they are trying to achieve with their portfolio,” he said. “Some of the funds used as core investments in portfolios are largely driven by index movements, so it makes sense to build the core of your portfolio using passive investments or structured products, and aim at outperformance by using selectively chosen boutique asset managers to drive alpha.”
According to Miller, over the last few years (since Sept. 2012), all company information has to be made available to everybody at the same time, “and as a result the active managers’ edge is gone because you have data and information coming to the market place, and a more efficient market, which makes it more difficult for fund managers to have that edge to create outperformance so they just track the index”.
“We have now a global set up and more volatility in the market,” said Miller. “Some models were designed 20 or 30 years ago that have not evolved and that’s why trackers have become so popular.”
SCM research, said Miller, shows that if a retail investor buys a passive fund as an alternative to actively managed funds they would save $106m a year, which again raises the issue of not providing the information people need to make an informed decision.
This issue, said Miller, is being taken very seriously by regulators in Denmark, Sweden, US, Australia and even by the European Markets & Securities regulator (ESMA), yet in the UK “investors continue to be hoodwinked”.
“There has been a shameful lack of investigation into closet index tracking in the UK,” said Miller. “This could end up becoming the biggest mis-selling scandal and the regulator doesn’t seem to be concerned as it has been with other segments of the market such as the structured solutions market.”
The structured products industry has seen regulators overbearing on the structured investments market and being very granular on transparency, cost, and customer outcomes, said Dale, but “we have not seen any regulatory reports with that degree of detail on the asset management industry”.
“At the UK SPA we have discussed the finding of the thematic review on structured products and worked very hard to address the issues but the damage caused to the industry takes months to repair,” said Dale. “We have not seen the regulator saying anything about actively managed funds charging excessive fees while underperforming, and we also see huge differences between annual management charges and total expenses charges, and that has to change.”
Click in the link to read the SCM Direct report.