Financial regulators have in the last few years focussed their attention mostly on misconduct within the banking industry, but now the spotlight may be turning more towards behaviour in asset management funds. This is a huge industry which, in the UK alone, controls the investment of £6 trillion. Any mis-selling issues affecting these funds could have an impact on almost everyone, particularly because of the potential effect on pension fund investors. This is why findings that a significant number of investment funds may be liable to investors for losses arising from “closet index tracking” are of serious concern.
The FCA recently highlighted the issue of closet index tracking, also known as “index hugging”, in its Asset Management Market Study Final Report. Closet indexing funds are investment funds which are marketed to investors as being actively managed, but which in reality are simply passive funds which track the relevant benchmark index. Since actively managed funds can charge much higher fees than passive funds, the practice has led to allegations that investors are being misled into paying extra for a service which they are not receiving.
The FCA estimates that there is around £109 billion in “active” funds that closely mirror the market which are significantly more expensive than passive funds. This follows an earlier finding by the FCA in 2016 that of 23 funds reviewed, 7 did not include a clear description of how assets are managed and of those, 5 used a benchmark-related approach which was not disclosed and one fund used jargon that a retail investor might not have understood.
However, despite being aware of the scale of the problem following a two year investigation into the asset management industry, the FCA has decided to take no action against any funds suspected of being closet trackers. Furthermore, the FCA has refused to disclose to investors the identity of the suspect funds.
Action by ESMA
By contrast to the FCA’s dilatory performance, the European Securities and Markets Authority (ESMA) has taken a more active approach. In 2016, ESMA found that almost one in six “active” equity funds across Europe could be closet index trackers. It stated that this formed part of the broader issue of the effectiveness of investment disclosure and the legitimate expectations of investors in respect of the service provided by asset managers, and it asked national regulators in the EU to investigate. 
ESMA’s concerns were that:
- investors could be making investment decisions based on an expectation that they would be provided with a more active fund management service than they received in practice and might therefore be paying higher management fees than that usually envisaged for passive management services;
- investors might be exposed to a different risk/return profile than they expected; and
- asset managers might not be providing clear descriptions of how funds are managed in key disclosure documents such as their prospectuses and Key Investor Information Documents (KIID).
Current fund disclosure rules require fund managers to provide investors with information that is fair, clear and not misleading. ESMA recommended that managers should provide investors with an accurate interpretation of the performance objectives of the fund and explain the amount of risk taken to generate that return in line with their obligations under the KIID Regulation.
The KIID Regulation requires information to be given on whether a collective investment fund allows for discretionary choices in regard to investments, and whether this approach includes or implies a reference to a benchmark and, if so, which one. Where a reference to a benchmark is implied, the degree of freedom available in relation to this benchmark should be indicated and where the fund has an index tracking objective, this should be stated.
ESMA analysed data for 1,250 investment funds. The quantitative analysis provided initial indicators of potential closet indexing funds. This was complemented by qualitative research into the documentation of those funds, to check whether the potential closet indexers were describing themselves as active managers in their prospectuses and KIID documents. The methodology used showed both the percentage of the fund portfolio which did not coincide with the underlying benchmark (the “active share”) and the volatility of difference between the return of the fund and the return of its benchmark (the “tracking error”). In relation to a given equity index, low active share and low tracking error indicate that the portfolio of a fund is close to that of the respective index, which could be a sign for passive management fund management.
The results of their analysis were that funds with an active share of less than 60% and a tracking error of less than 4% were classified as potentially being closet indexes. This represented 15% of the equity funds analysed. ESMA noted that part of its analysis employed a statistical model and recommended that national regulators follow up with a more detailed anaylsis using the actual information provided by funds to investors.
Norwegian and Swedish regulators have been the most active in following up ESMA’s findings. For example, the Norwegian Consumer Council has planned to bring a lawsuit against the country’s biggest bank, DNB, arguing that 137,000 customers were charged too much for asset management. The Norwegian regulator ordered DNB to cut the costs of one of its funds or alter its investment approach. In Sweden, which was the first European company to announce a government lead investigation into closet tracking, the regulator produced a report highlighting several instances of the practice.
Action available to investors
By contrast to the approach taken by ESMA and in Scandinavia, the FCA provided no details of its investigation or the methodology it used. The failure of the UK regulator to take effective action on this issue is disappointing, but investors may well be able to bring their own claims against funds who have been guilty of the practice. Many of the investors are likely to be pension fund trustees. The legal claims may include breach of contract, misrepresentation or even fraud.
Expert analysis of the funds’ data, together with legal analysis of their documentation, will be required to show whether a particular fund has misled potential investors with regard to its investment approach. For example, discrepancies may be most apparent where a fund manager is found to be offering two funds which are essentially the same product but at different charging rates. Once suspect funds have been identified, it should be possible for investors to join together to bring group action claims.