Lifting the lid on closet index tracking funds

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On February 1st 2015 an academic paper titled Indexing and Active Fund Management: International Evidence was published by four respected professors at universities based both in Europe and the United States. While this paper slipped quietly into the world of academia, as is usually the case with this type of publication, their conclusions have the potential to shake the mutual fund industry to its very core.

The Professors collaborated to examine the relationship between index tracker products – typically low cost Exchange Traded Funds (ETFs) designed to track a particular index – and actively managed funds in the mutual fund industry. Amongst their findings was the extent and size of “closet index tracking” particularly evident in the European mutual fund industry.

Closet index tracking funds claim to be actively managed funds and charge fees associated with active management but which are in fact simply tracking a benchmark or index.

Closet tracking has been labelled a “gigantic misselling phenomenon” and that it is an “absolute disgrace” regulators have not done more to tackle this issue.

Let’s take a closer look at the cost and extent of this scam and what benchmark hugging funds might be unnecessarily costing UK investors.

In the paper, our professors studied 975 funds domiciled in the UK with collectively $504 billion under management. Of these funds, 46 were identified explicitly as index trackers while 929 were identified as active funds. However, the professors concluded that 32% of the supposedly active funds or 297 were in fact closet index trackers.

This means the UK mutual fund industry may be overcharging their clients on as much as $146 billion of assets currently under management in closet index tracker funds.

If this overcharging is as much as 1% per year relative to holding a low cost ETF, taking into account the active fund fees and additional platform or provider fees, then this means that $1.4 billion or nearly £1 billion is being needlessly taken from investors accounts each and every year.

Carl Rosen, chief executive of the Swedish Shareholders Association said “The likelihood of these funds outperforming low-cost index funds was less than microscopic”. Andrew Clare, who holds the chair in asset management at London’s Cass Business School said: “Closet tracking is the active fund management industry’s dirty little secret”.

In coming weeks, we will start to identify the UK’s top closet index tracking funds and using our proprietary Hound™ tool – we will reveal the best low cost alternative ETF index tracking funds and how much you could save by switching to a Selftrade ETF account, if you are unlucky enough to be invested in any of these products.