In March, we published an article addressing the issue of closet tracking1 in response to the announcement of an unofficial Financial Conduct Authority (FCA) sponsored redress scheme, where 64 funds had agreed to compensate investors a total of £34m and change their marketing materials.
The closet tracking issue has been on the regulatory horizon across multiple jurisdictions in Europe for a number of years. However, the past few months have seen an uptick in regulatory interest on four fronts.
Firstly, in October, the French regulator, the Autorité des marchés financiers (AMF), announced its plans to conduct an investigation into potential closet trackers. Finding that the “active share” approach2 previously used by ESMA had serious limitations, the AMF intends to apply three factor-based models in order to detect potential closet trackers. The three proposed factor-based models are (1) tracking error (the difference between the return of the fund and the return of its benchmark), (2) R2 (the ratio between explained variance and total variance) and (3) style-shifting activity (measuring changes in exposures to a number of market factors between two quarters).
Secondly, also in October, the Swedish government proposed new rules concerning disclosures to be included on websites, leaflets and annual reports. The proposed disclosures would cover how the fund differs from the benchmark that it has selected, thereby identifying possible closet trackers.
Thirdly, in November, ESMA announced that it was looking at publishing guidance or a Q&A to clarify disclosure requirements in response to concerns that some managers are failing to disclose information about benchmarks to investors (which would result in investors being unable to easily identify funds which are closet trackers).
Finally, this month, the Central Bank of Ireland announced that it is looking at over 2,000 UCITS funds to check for closet trackers. This study will take the active share methodology used by ESMA in its 2016 study into account.
The action taken by the FCA earlier this year and the more recent activity of ESMA and the regulators in France, Sweden and Ireland demonstrates that the closet tracking issue is not going away. We consider it likely that regulatory (and investor) scrutiny of the closet tracking issue will intensify across Europe in 2019. Managers should be taking the opportunity as the year-end approaches to ensure that funds are being managed in a consistent manner to that described in their marketing materials and, where appropriate, changes should be made.
1 Closet tracking is where active asset managers charge investors the premium associated with active management but whose portfolios are very similar to those of a lower cost tracker fund.
2The percentage of a fund’s portfolio that does not coincide with its underlying benchmark
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