Kill the Filler The Costs of Closet Tracking By Simon Evan-Cook - Senior Investment Manager, Premier Multi-Asset Funds Executive Summary This paper poses a simple question: why should funds that are 60% passive be classed as active when their performance is judged? To subscribe to updates, email us at: info@premierfunds.co.uk Investment funds can be grouped by how active they are. Doing so highlights a part of the fund management industry where fund holders are receiving poor value for money: closet trackers. These funds provide a service that is little different (and frequently inferior) to cheaper index trackers, but charge higher active fees. Visit: www.premierfunds.co.uk Despite frequently being more passive than they are active, closet trackers are classed as active in studies gauging the performance of the average active fund. This has unfairly tipped the debate in favour of passive investing in recent years, as closet trackers are likely to underperform. 58billion of investors money is held in equity funds that can be classed as closet trackers this is 29% of the total. The equity sector is notably worse than other IMA sectors. In the Japan sector, for example, only 3.2% of fund holders wealth is held in closet trackers. equity closet trackers have underperformed cheap, genuine trackers by 0.3% a year over the current market cycle, but have lagged highly active funds by 2.9% a year. At a market level, investing is a zero-sum game. But within the market, we believe persistent outperformance from good active managers is made possible by (among other factors) persistent underperformance from the large swathe of poorly-managed closet trackers.
Kill the Filler The Costs of Closet Tracking While we frequently lock horns with the passive camp, we think the real enemies are closet trackers. This sub-sector of the investment industry masquerades as active management to justify higher fees, but provides a service that is little different (and frequently inferior) to cheaper index trackers. The most obvious problem with closet trackers is that they are poor value for money. Holders of such funds are paying significantly more than holders of the cheapest index trackers, yet they receive worse results (mainly, but not entirely, because of the higher charges they pay). That s not the only problem. Closet trackers also unfairly tip the passive-active debate in favour of passive. Despite being neither one nor the other, they are classed as fully active funds in statistical studies. Given they are all-but-a shoo-in to underperform the market by even more than genuine trackers, they inevitably drag the performance of the average active fund down. It is like trying to calculate the average fuel efficiency of cars in the, but including lorries in your study. Previously we ve had to grumble about this in private, as we had no way of gauging the size or impact of this sub-industry. Now, however, we have new methods of measuring how active funds really are. So we have crunched the data, and can now expose this corner of the fund industry to sunlight. The results are illuminating. Our Killer-Filler charts (see below) examine six of the main equity fund sectors. We split each of these into four categories based on how closely they resemble the index: Highly Active ; Active ; Closet Index and Index Tracker *. By doing so, we can see the proportion Chart 1: IMA equity fund sectors split by Active Share scores, which measure how different funds are from the index. %of Sector 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% IMA Sector Breakdown - By Weight of AUM Asia Ex- Japan Europe ex- Global Emerging Markets Killer Filler Active Share Score Highly Active (80+) Active (60-80) Closet Index (15-60) Index Trackers (0-15) Japan North America See notes below and page 6 for full disclosures on data for the above chart. Past performance is not a guide to the future. *We have used the active share measure to create these groups. For an individual fund, its active share score measures how different it is from its index benchmark based on stocks held. An active share of zero means the fund holds exactly the same stocks as the benchmark in exactly the same proportions (a perfect tracker). An active share of 100 means the fund holds none of the same stocks as the index (i.e. it s all killer, no filler ). In our book, any fund with a score of 60 or less is referencing its index, and is therefore a tracker (most likely a score of 15 or less) or a closet tracker (anything in between those two scores). 2
of investors money that is being invested actively, and how much is just copying the index (openly or otherwise). We can draw many conclusions (and we may cover these in later notes), but the most striking one is that many British investors in equity funds are losing out. Almost 30% of the money in the IMA s two main equity sectors is held in closet tracker funds (the orange section on the charts). This is much more than other fund sectors: the next-worst is Global Emerging Markets, in which only 15% of fund holders wealth is surreptitiously aping the market. That means there is 58bn of investors money stuck in Equity funds that are doing little more than copying the stock market, but charging active fees for doing so. As the chart below shows, the weighted average annual ongoing charge these investors are paying is 1.43% - well above the 0.61% paid by tracker holders, and only fractionally less than the 1.55% paid for the market s most active funds. Chart 2: Combined IMA equity fund sectors split by Active Share scores, which measure how different funds are from the index, and weighted annual ongoing charges paid in each category (in brackets) % of Sector 100% 90% IMA Equity Funds - grouped by how active Vs FTSE All Share Index (Average Annual Ongoing Charge in Brackets) (1.55%) Active Share Score Highly Active (80+) 80% 70% 60% (1.61%) Killer Active (60-80) 50% 40% 30% 20% (1.43%) Filler Closet Index (15-60) 10% (0.61%) Index (0-15) 0% Weighted by AUM Data above combines funds from the IMA s All Companies sector and the Equity Income sector. See and page 6 for full disclosures on data for the above table. Holders of these equity funds could easily save themselves upwards of 756million a year. This is the amount that could be saved if they all switched to the cheapest tracker in our study, which charges 0.12%. That is a large sum in anyone s book. Watering the Whisky You may wonder why, as proudly active investors, we are suddenly sounding like tracker salesmen? The truth is that we re frustrated by hearing the same anti-active case over and over again. An argument along the lines of: investors can t outperform the market because, in aggregate, they are the market. So the average will receive market performance less charges. However, as an individual, you don t have to invest with an average manager. We carefully pick genuinely active ones that fall into the blue and green boxes. And they are able to repeatedly outperform because of the poorly-run funds in the orange box, which are more concerned with 3
looking like the market than finding attractive stocks. Closet trackers are therefore prepared to sell perfectly good investments to shrewder managers because they ve dropped in price, or to buy the expensive - but larger - stocks our active investors no longer want. The table below shows the performance of each of the equity categories over various time periods**. It suggests the most active investors have received the best results, despite paying higher charges than tracker funds. They have firmly beaten the market, while closet trackers have underperformed. This backs our case for genuinely active management: Once you remove the closet trackers from the stats (which most studies include as active ) what is left works well. Table 1: Annualised total returns (%) generated by the different categories within the combined IMA equity fund sectors**. Peak (31.10.07) to Peak (04.09.14) 10 Years 7 Years 5 Years 3 Years 2 Years 1 Year Highly Active 7.5 10.3 6.8 14.0 15.7 16.7 2.1 Active 5.9 9.0 5.2 11.2 13.0 13.9 1.5 Tracker (low cost) 4.9 7.8 4.0 9.7 10.4 11.0 0.9 Index (FTSE All-Share) 4.8 8.0 3.9 10.0 10.8 11.4 1.0 Closet Tracker 4.6 7.6 3.9 9.9 11.1 12.1 0.8 Tracker (high cost) 4.0 6.9 3.1 8.6 9.0 9.6-0.1 See notes below and page 6 for full disclosures on data for the above table. Past performance is not a guide to the future. Critics of active investing have long maintained it is too hard to pick a good active fund. But this shows how easy it is to immediately avoid most of the weaker funds that drag down the average fund statistics. Naturally there is more to it than that, but we did this with one simple measure: Active Share. Unfortunately, Active Share is not widely used by the industry yet, and it is certainly not understood by the investing public. We hope this will change. ** Notes on the Performance Data The table is ranked according to how each category has performed from the peak in 2007 preceding the financial crisis to the recent peak in September, as we believe this captures different market conditions and is therefore a fairer comparison. We split the tracker category in two: those with annual ongoing charges of less than 0.5% ( Low Cost ) and those charging more than that ( High Cost ). In doing so we highlight an even more corrosive section of the funds market than closet trackers: openly passive funds that still manage to charge active fees. The category performance is not as scientific as in previous studies we have carried out (due to time and data limitations). The constituents of each category are based on those in the sector as at 30 th June 2014, so it is susceptible to survivor bias. They are also unweighted, so smaller funds have the same prominence as large ones. Ideally we would test this over longer time periods too, as this comparison is just one point in time. We may correct for these in future research, but should you doubt the general tone of our results we recommend reading the excellent Active Share and Mutual Fund Performance by Antti Petajisto, then of NYU Stern School of Business. This has similar findings, but with the complete statistical robustness that, alas, time prevented us from adding here. See page 6 for more notes on performance. 4
Why are the Equity sectors particularly bad? Another valid question is why are British fund buyers getting a raw deal when they buy equity funds, but receiving value for money when they buy a Japan fund? (Or why is the orange part of the bar on Chart 1, Page 2 so much larger for equity funds than any other sector?) We believe it is because of the make-up of products held by less sophisticated fund buyers. Firstly, such buyers have a bias to home-market funds. So when Mr & Mrs Smith walk in to their building society, or speak to their life insurance provider, the path of least resistance is to buy an own-brand equity fund, not a Japanese equity fund. These investors are also the most likely buyers of closet trackers: They have no way of knowing whether a fund is genuinely active or not, or even that such a thing matters. They are also less likely to dump a fund unless short-term performance is really bad. As such, providers in this part of the market (and it is a separate market - closet trackers are not marketed to professional fund buyers) make sure this doesn t happen by hugging the index. This has the unfortunate corollary that performance is never really good either, and is usually worse than the tracker because of the active charges. We believe this combination of home-bias and cost naivety on the part of their customers means that closet tracker providers have far larger equity funds than overseas equity funds. This would explain the outsize weighting of closet trackers in the equity sector (across the six sectors we looked at, 76% of the money held in closet trackers was in equity funds, but equities make up only 8% of the global stock market - see chart). Chart 3: The fund industry s closet tracker industry split by geographical exposure of funds. Asia ex-japan Europe ex- Global Emerging Markets Japan North America See page 6 for full disclosures on data for the above table. Linking this back to the argument for good active managers being able to exploit this weaker part of the market, we suspect this situation is not unique to the. If this home-biased, quasi-tracking tranche of poorly run money exists in other markets, it highlights one pool of poor decisions from which the best managers can consistently extract their alpha. For every winner in a market there has to be a loser, and this part of the market looks like a hotspot for the latter. 5
Notes on Data and Calculations All performance data is total returns, after charges, in sterling to 31st October 2014 (unless otherwise stated). Past performance is not a guide to the future. All raw data sourced from Morningstar. For comparison against the market, the indices listed in the table below were used. Not every fund in each sector uses the same index as a benchmark, something that has to be considered in assessing funds level of activeness and performance. We have used FTSE indices for licensing purposes. Sector Asia ex-japan Europe ex- Global Emerging Markets Japan North America Index Used FTSE All Share FTSE World Asia Pacific ex-japan FTSE World Europe ex- FTSE Emerging FTSE Japan FTSE USA For the, we combined the funds in the IMA s Equity Income sector and the All Companies sector to gain a fuller picture of equity fund exposure. The fund charges were calculated on a weighted basis, with the weightings based on stated fund sizes. The charges quoted are based on the main share class as registered with Morningstar. It is worth noting this is currently a complicated area, as the cost of financial advice (a.k.a. commission) is included in many of these funds, but is stripped out of others that have clean share classes as their main share class. In both cases, the fund groups may have other share classes which charge lower fees. 6
Important Information The content of this report and its conclusions are for illustrative purposes only and are based on the author s findings and research based on statistics which have not been independently verified. Whilst every effort has been made to ensure the accuracy of the information contained within this report, we regret that we cannot accept responsibility for any omissions or errors. This report expresses opinions of,and provides information on underlying research and analysis conducted by, the author. This report is for information purposes only and does not constitute advice. Persons who do not have professional experience in matters relating to investments should not rely on the content of this document. Source: FTSE International Limited ( FTSE ) FTSE 2014. FTSE is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under licence. All rights in the FTSE indices and / or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and / or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE s express written consent. Issued by Premier Asset Management. Premier Portfolio Managers Ltd and Premier Fund Managers Ltd are ISA managers, authorised and regulated by the Financial Conduct Authority of 25 The North Colonnade, Canary Wharf, London E14 5HS and are members of the Premier and Premier Asset Management marketing groups. For your protection, calls may be recorded and maintained for training and quality assurance purposes Risk of investments Past performance is not a guide to future returns. The price of shares and any income from them may go down as well as up. Movements in exchange rates may also affect the value of investments. Please remember that the investments in this report are typically intended as either medium or long term investments. 14.11.1272/1911149899 7