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Don’t pay for inactive management

Beware the closet tracking funds.

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Justin Modray
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The FCA has hit the headlines by ordering some managers to compensate their investors a total of £34 million for charging active management fees on funds that were more tracker like (passive) in their behavior (according to the Sunday Telegraph).

This style of fund management (so called ‘closet tracking’) has been around for as long as I can remember. I’m not sure individual fund managers necessarily set out to do this on purpose, but it’s easy for those less confident in their abilities to play safe by largely tracking their benchmark index - as it reduces the risk of making a big mistake and looking bad. And in some cases, perhaps they are simply following orders from above where a fund provider feels the same way. History suggests this has not been uncommon amongst insurers and high street banks.

The trouble with this approach is that it usually reduces the likelihood the fund will beat the index after charges. And funds which almost always underperform their benchmark index do look bad. The bottom line is why pay 0.75%+ a year for a closet tracker when you can buy an index-tracker for a fraction of the cost? (often 0.20% or less).

The FCA’s focus appears to be on marketing material for these funds not making clear that they’re not very actively managed. It’ll be good to see this amended, but given I doubt many people read this stuff before investing it won’t eradicate closet tracking overnight.

This is a timely reminder to look carefully at funds before buying. We tend to blend index-trackers with active managers who invest quite differently – no closet trackers in sight. Our rationale is that active managers seldom beat the index year in year out, but some are likely to beat it overall long term. Rather than bet on one or the other, we hedge bets by using both. And using managers who invest very differently to the index provides another important hedge by significantly widening the investment net within a portfolio.

As a parting thought, fund managers are probably not the only ones in financial services charging for inactive management. From our experience that criticism could be levied at some financial advisers too. Most financial advisers charge ongoing advice fees each year, but not all provide much, if any, service in return. Let’s hope this issue is not too far behind fund managers on the FCA’s agenda.

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