In the last number of years there has been a regulatory focus on active investment management and performance. A number of key regulators including ESMA, the CBI and the FCA have reviewed the market for potential hidden “closet tracker” funds and published their findings, with a number of funds providing inaccurate information in their investor disclosure documents as regards investment strategy.
WHAT ARE CLOSET TRACKERS?
Closet trackers, also known as closet indexing or index hugging, refers to the practice of fund managers claiming to manage portfolios actively when in reality the fund stays close to a benchmark.
IMPACT OF CLOSET TRACKERS
The issues around ‘closet trackers’ form part of a broader issue on the effectiveness of investor disclosure and the legitimate expectations of investors in respect of the service provided by some asset managers.
Closet trackers may result in:
- Investors making investment decisions based on an expectation that they will be provided with a more active fund management service than they receive in practice and, therefore, may be paying higher management fees than that usually envisaged for a passive/not significantly active management service;
- Investors being exposed to a different risk/return profile than they expect; and
- Asset managers not providing clear descriptions of how funds are managed in key disclosure documents such as the fund’s Prospectus and Key Investor Information Document (KIID).
Closet Trackers are now the focus of regulatory scrutiny and a clamp-down across Europe with many regulators conducting reviews into the practice.
Click here to find out more about the developments across Europe and different results of their findings.
COMMON METRICS USED TO SPOT A CLOSET TRACKER
Across Europe, regulators and ESMA have shown themselves adept at using data driven oversight to spot potential closet trackers, through large-scale data driven oversight using measures such as:
R-SQUARED
Similar to Tracking Error, R-squared measures the relationship between the portfolio’s performance and the benchmark’s performance. It is the proportion of variance of the fund performance explained by the benchmark performance. The higher the R-squared, the more similar the management style is to that of a tracker fund.
ESMA also used this metric in their study of potential closet trackers. In their study, if a fund was found to have an active share of less than 50%, a tracking error of less than 3% and a R2 of more than 0.95 (95%), it was classified as potentially being a closet tracker. Using a methodology which combined the three metric (Active Share, Tracking Error & R-squared) they found the following results:
| Product | FCA Response |
|---|---|
| FX forwards | FX Forwards, and FX Swaps, are derivatives. As outlined in FS 19/01, and explained on our website, we consider that derivatives, if offered to retail investors, would fall within the definition of PRIIPs |
| REITs | As outlined in FS 19/01, it is the responsibility of the manufacturer of REITs to determine whether the REIT is a PRIIP or not, on a case-by case basis |
| Listed Investment Companies | As outlined in FS 19/01,we maintain our view that if a collective investment undertaking falls within the definition of an ‘alternative investment fund,’ and is made available to the retail market, then it should be considered a PRIIP. A listed investment company would fall under that definition, notwithstanding that it is also a body corporate |
| Exchange Traded Derivatives (ETDs) | We maintain our view that ETDs are derivatives. As explained on our website, we consider that derivatives, if offered to retail investors, would fall within the definition of PRIIPs |
| SPACs | Generally, we would not consider a SPAC to fall in scope of the PRIIPs Regulation where it is publicly listed and follows the traditional model where the investor can either swap their shares in the SPAC for shares of the merged company or redeem once the acquisition is completed. However, it is the responsibility of the manufacturer to consider the features of a SPAC, particularly an unlisted entity, and determine whether it could constitute a PRIIP |
| Royalty Companies | We would typically consider a royalty company to be out of scope of the PRIIPs Regime where the assets held by retail investors are publicly listed corporate shares. However, it is the responsibility of the manufacturer to determine whether the Royalty Company offering is a PRIIP or not, on a case-by-case basis |
| US ETFs | As outlined in CP 16/18, a third-country manufacturer or distributor of a PRIIP to retail clients in the UK will be required to prepare and produce a KID |
| Sukuk | As the characteristics of a Sukuk can vary, it is the responsibility of the manufacturer to determine whether the Sukuk is a PRIIP or not, on a case-by-case basis |
| Regulated Covered Bonds | It is the responsibility of the manufacturer of regulated covered bonds to determine whether the characteristics of the bond mean that it constitutes a PRIIP or not, on a case-by-case basis |
| Sovereign Bonds | We do not consider sovereign bonds to fall within the scope of PRIIPs |
Across Europe, other regulators have conducted investigations into Closet Trackers using various methods.
Click here to find out more about other methodologies used and their corresponding results.
ACTIVE SHARE
Active Share examines how much of a fund’s holdings differ from its underlying benchmark, with the active share showing the percentage of the portfolio which does not coincide with the underlying equity benchmark. The active share varies between 0% and 100% – the higher this figure is, the more a fund’s management will be considered active. ESMA used this as one of the metrics in their 2016 study.
In conjunction with the Active Share metric, they used the above Tracking Error in their methodology. In their results, the following were classified as potentially being closet trackers:
- Funds with an active share of less than 60% and a tracking error of less than 4%
- Funds with an active share of less than 50% and a tracking error of less than 3%
| Issue | Current Schedule 13D | Proposed New Schedule 13D | Current Schedule 13G | Proposed New Schedule 13G |
|---|---|---|---|---|
| Initial Filing Deadline | Within 10 days after acquiring beneficial ownership of more than 5% or losing eligibility to file on Schedule 13G. Rules 13d-1(a), (e), (f) and (g). | Within five days after acquiring beneficial ownership of more than 5% or losing eligibility to file on Schedule 13G. Rules 13d-1(a), (e), (f) and (g). | QIIs & Exempt Investors: 45 days after calendar yearend in which beneficial ownership exceeds 5%. Rules 13d-1(b) and (d). Passive Investors: Within 10 days after acquiring beneficial ownership of more than 5%. Rule 13d1(c). | QIIs & Exempt Investors: Five business days after month-end in which beneficial ownership exceeds 5%. Rules 13d1(b) and (d). Passive Investors: Within five days after acquiring beneficial ownership of more than 5%. Rule 13d-1(c). |
| Amendment Triggering Event | Material change in the facts set forth in the previous Schedule 13D. Rule 13d-2(a). | No amendment proposed – material change in the facts set forth in the previous Schedule 13D). Rule 13d-2(a). | All Schedule 13G Filers: Any change in the information previously reported on Schedule 13G. Rule 13d-2(b). QIIs & Passive Investors: Upon exceeding 10% beneficial ownership or a 5% increase or decrease in beneficial ownership. Rules 13d-2(c) and (d). | All Schedule 13G Filers: Material change in the information previously reported on Schedule 13G. Rule 13d-2(b). QIIs & Passive Investors: No amendment proposed – upon exceeding 10% beneficial ownership or a 5% increase or decrease in beneficial ownership. Rules 13d-2(c) and (d). |
| Amendment Filing Deadline | Promptly after the triggering event. Rule 13d-2(a). | Within one business day after the triggering event. Rule 13d-2(a). | All Schedule 13G Filers: 45 days after calendar yearend in which any change occurred. Rule 13d-2(b). QIIs: 10 days after monthend in which beneficial ownership exceeded 10% or there was, as of the monthend, a 5% increase or decrease in beneficial ownership. Rule 13d-2(c). Passive Investors: Promptly after exceeding 10% beneficial ownership or a 5% increase or decrease in beneficial ownership. Rule 13d-2(d). | All Schedule 13G Filers: Five business days after month-end in which a material change occurred. Rule 13d-2(b). QIIs: Five days after exceeding 10% beneficial ownership or a 5% increase or decrease in beneficial ownership. Rule 13d-2(c). Passive Investors: One business day after exceeding 10% beneficial ownership or a 5% increase or decrease in beneficial ownership. Rule 13d-2(d). |
| Filing “CutOff” Time | 5:30 p.m. eastern time. Rule 13(a)(2) of Regulation S-T | 10 p.m. eastern time. Rule 13(a)(4) of Regulation S-T | All Schedule 13G Filers: 5:30 p.m. eastern time. Rule 13(a)(2) of Regulation S-T. | All Schedule 13G Filers: 10 p.m. eastern time. Rule 13(a)(4) of Regulation S-T. |
TRACKING ERROR
Tracking Error assesses how closely a fund tracks a benchmark by comparing the performance of the fund to that of the benchmark. Passive strategies, which aim to replicate a benchmark’s return, often use tracking error to measure their success. This metric was used by both ESMA and the FCA in their respective studies.
In the FCA Asset Management Market Study, they provided the below diagram which displays the ongoing charges figure (OCF) compared against the tracking error. A low tracking error generally means a passive fund’s performance closely follows the benchmark. In their study, they found that there is around “£109bn in expensive funds that closely mirror the performance of the market (they have a tracking error below 1.5)” – these were found to be considerably more expensive than passive funds.
SUMMARY
The work by the FCA, ESMA, and other European Regulators on FCA Assessment of Value and on closet trackers over the last number of years shows the importance and value to the regulators of data, and their willingness and intention to use this to identify issues in the functioning and performance of the fund management industry.
It should also be noted that although the above metrics are useful tools as indicators of potential closet trackers, as the EFAMA has stated, these metrics should only be used as “a first step in the investigation of closet indexing”.
Closet trackers are the investment management equivalent of wolves in sheep’s clothing – with the spotlight well and truly on them, it is unlikely they are going to remain unnoticed in the future.
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