According to the FT today, GBP 58bn is struck in UK closet trackers – fund managers who claim to be active managers but are in fact doing no more than tracking equity indices. The returns they deliver, after fees are then obviously less than passive investing.
According to the Danish regulator, Finanstilsynet, almost 1/3 of the 188 domestic funds in Denmark could be classified as closet trackers. In the UK the estimate is that 46 per cent of fund managers are closet trackers. Market trackers such as the ones offered by Vanguard charge fees that are 80 per cent less compared with closet trackers.
In Europe Eur 10tn is being managed by funds, the Brussels-based Financial Services User Group has found that, after fees that there is no asset class where active managers outperformed the index for the period 2003 to 2012. Only 20% of the asset managers who were in the top quintile in the first 5 years were also there in the last 5 years.
Regulators in Europe are now focusing on this ‘abuse’ by closet trackers. Are regulators in a position to asses a fund managers performance as a group? How can the concerns be addressed in a meaningful way?
The way to address is not to try and assess what the active share of the fund manager is. An active share of 100 implies that none of the index constituents are held in the fund – implying zero participation in the market. Measuring the active share is far more complicated. For example, if we take the FTSE 100 Index, it is possible to track the performance of this index closely using a much smaller subset or say 30 stocks. One would then classify such as fund as 70% active. This is absurd as the end objective remains tracking the performance of the FTSE 100, be it with higher volatility. Active share should also take into account how the weights of the managers portfolio differs from the weights in the index.
Regulators should not be seeking to know the active share for the sake of it because measuring the active component does not make any sense. From time to time it can be a good strategy for active managers to track the index. The last 3-4 years, starting from extremely depressed levels, and supported by QE, the market indices have been performing very well. Given that this has been a liquidity driven rally market returns have been very good. To expect active managers to have beaten those returns would have been very difficult. To be penalized active managers for participating in the liquidity driven move up sounds like regulator over reach. Performance of active managers would have been much worse if they increased the active component since the financial crisis ended.
Manager skills are most important when markets are correcting or when markets are not doing anything for long periods.
What is missing in our economic system is financial literacy. We need to educate investors about the financial markets and how to use them to achieve their investment goals.
The way forward must be to align Manager’s interest with those of the Investors. If the benchmark is a market index, Manager Fees should be increasingly performance based. The idea should be to be able to charge significantly higher fees when performance exceeds the passive tracker for the same amount of risk as measured by volatility and drawdowns.
Different investors (individuals and institutions) should have different expectations on returns based on their personal circumstances and risk aversion. Managers should be rewarded when client objectives are being met. To start thinking about relative performance to a market index, already starts the discussion on the wrong footing.
Benchmarking means that one has to be prepared to lose up to 55 per cent your capital, as the S&P 500 did by late 2008. It is a poor way to invest for long term capital growth because passive index tracking can be very risky and quite inefficient.
Long term investing should have an overall objective. Getting market returns or something close to it is not a sound objective because market returns cannot be anticipated or properly managed. Trying to achieve a return of say 10-year treasury yields + 5-7 equity risk premium is a more worthy goal and requires genuine manager skills.
Investment risks have to be monitored, measured and managed.
At Algoam we are happy to earn in large part performance based fees.