On 2 February 2016, ESMA published the results of a research study it conducted between 2012 and 2014 to determine whether closet indexing was being carried out at an EU-wide level. The results indicated that from a sample size of 2,600 funds, between 5-15% of UCITS equity funds could potentially be closet indexers.
Following its review of ESMA's research, the European Fund and Asset Management Association (EFAMA) published a Report on Closet Index Funds on 26 July 2016. While emphasising the importance of identifying funds that are not actively managed but claim to be, the report also highlights the limitations of using a quantitative analysis based on active share and tracking error to identify closet index funds, noting that there are funds that combine a low active share and a low tracking error but are truly actively managed.
EFAMA takes the view that closet indexing raises two main questions:
- How can national competent authorities identify closet index funds?
- Is there a need to take action to better protect investors?
Identification of closet index funds
The report highlights that a wide range of factors must be taken into account to assess whether a fund is being actively managed and that an analysis based on a few quantitative indicators (particularly percentage of active share) can only be a first step in the investigation of closet indexing.
EFAMA agrees with ESMA that definitive evidence requires a detailed, fund-by-fund follow-up analysis before the national competent authorities can decide that a low active share fund that identifies itself as being actively managed is a closet index fund (and ultimately require the fund managers concerned to correct the information provided to investors).
EFAMA believes that the current UCITS regulatory framework provides a good basis to ensure that investors receive appropriate information and does not see the need to add new regulatory requirements and disclosure obligations. The report, however, recommends that the current rules on fund disclosures are properly complied with by UCITS asset managers and, as the case may be, enforced by relevant national supervisors.
EFAMA also recognises that there may be a need to clarify the practical interpretation of some of the existing legal requirements and is currently looking into this matter. In the meantime, it has adopted two recommendations to further improve the quality of disclosures to investors:
- When preparing the fund's legal documentation and related marketing materials, UCITS management companies should take particular care to disclose in a fair, complete and understandable manner the essential characteristics of the fund, especially when describing the degree of freedom available to the portfolio manager in relation to the fund’s benchmark (as is already required under the UCITS KIID Regulation)
- For UCITS presenting themselves as being actively managed, it would also be good practice for UCITS management companies to keep internal records and evidence as appropriate to be able to explain (ex post) to their national competent authorities that the disclosures that have been made to investors truly reflect the level of active management provided by the fund (having regard to the specific circumstances of each individual UCITS)