News analysis: Schemes have been urged to closely monitor the investment strategies and risks taken by their active managers as new research shows nearly half of such UK managers are closet indexers.
Index cloning is when active managers, who generally charge higher fees, mirror indices.
Within a typical UK equity fund, 40 per cent of the portfolio is identical to the index it is trying to beat, according to the report by investment manager SCM Private. This is compared with 25 per cent in the US.
If you are going to be using active management you probably want to be invested in managers who are capable of outperforming to overcome their fees
Closet indexation has been going on within the asset management industry for a number of years, according to John Belgrove, partner at consultancy Aon Hewitt.
He said indices should be a guide for analysis; however, benchmarks have become the drivers for portfolio construction.
Clever marketing has meant closet index funds are unwittingly used by investors, he added.
“Many investors will think that they are buying an active management portfolio with the active manager’s best insights in the portfolio, but really has its product tracking the benchmark with bells and whistles at the margin,” Belgrove said.
Core active managers are in the middle of a spectrum between pure index tracking and unconstrained active management. These managers are looking to beat the benchmark by between 1 and 1.5 percentage points annually and act in a similar manner to the index, only taking positions at the margin, according to Belgrove.
Investors could have saved around £3bn in fees over the past five years if they had used passive managers rather than underperforming closet index funds, the research claims.
SCM Private looked at 127 UK equity funds, managing £120bn of assets.
Prompting the move to passive management
Jane Welsh, senior investment consultant at Towers Watson, said closet indexation is one reason people have moved away from low-risk, core active management strategies and towards passive management or smart beta alternatives.
“If you are going to be using active management you probably want to be invested in managers who are capable of outperforming to overcome their fees,” she added.
Schemes can also look at how managers make investment decisions and how they think about risk, as well as style biases within a manager's investment strategy, Welsh said.
Unless a fund has an active share of at least 85 to 90 per cent it has little chance of outperforming the benchmark, according to Stephen Millar, UK managing director at Skagen Funds.
“[There have been] many instances over the years where fund managers have taken on too much money. [They’re] then forced to invest that money into companies you wouldn’t necessarily have invested in when the strategy set itself up,” Millar said.
Millar stressed that true active management completely ignores the benchmark and looks at the fundamentals of the company it wishes to invest in.
Active managers charge either a performance-related or a basic fee. A good signal for schemes looking for a truly active manager is one that charges a performance-related fee, according to Millar, as opposed to a basic fee where managers will be encouraged to improve profitability by increasing the level of assets held.
