The Financial Conduct Authority (“FCA”) today published its Thematic Review (TR 16/3) on “Meeting investors’ expectations” as part of its appraisal of the asset management sector. In TR 16/3, the FCA highlights three strands where firms may be exposing investors to risk: clarity of product descriptions, adequacy of oversight and governance, and distribution.

The review picks up on the phenomenon of “closet index tracking” (also known as “index hugging”) in which a fund is marketed as actively managed (and charges a management fee commensurate with this), when in fact it is passively managed by simply tracking an index. In other words, the firm’s stated investment management strategy does not align sufficiently with how it is actually managing assets.

The FCA found that seven of the 23 funds covered by the review did not include a clear description of how assets are managed in their key investor information documents, and five of these seven appear to be closet index trackers. The FCA’s focus on closet index tracking is unsurprising, given that this was recently raised as an issue by the European Securities and Markets Authority (see their statement dated 2 February 2016).

To ensure compliance with FCA rules, firms should make sure that investors are provided with clear and accurate information about how funds will be managed, including whether they will passively track a benchmark, or, in the case of active funds, the latitude afforded to the fund manager vis-vis the benchmark. To achieve this outcome, firms should consider involving the fund manager in drafting the prospectus – a behaviour held out as good practice by the FCA, for achieving an appropriate level of detail and specificity about the investment strategy, and also for reducing the likelihood of a deviation from the strategy further down the line.

Other common pitfalls highlighted by the FCA and warned against in the review include: (a) a failure to ensure that funds stick to their investment strategy after they are no longer being marketed to investors, and (b) a failure to monitor the distribution of the funds through marketing channels to ensure they are only marketed to appropriate investors.

Firms involved in the Thematic Review will be contacted but the FCA also cautions senior managers and those involved in governance to consider whether the concerns raised in this TR 16/3 are reflected in their own operations and to minimise the risks accordingly. This will be considered through routine supervision.