In the closet with “Closet Tracking”

Closet tracking is unlikely to be the fund industry's PPI moment despite what some commentators are saying.

The “closet tracker” issue has been running across various European jurisdictions for some time (see Closet Tracker timeline). A burst of excitement has followed the soft announcement of an unofficialFinancial Conduct Authority (FCA) sponsored redress scheme by which 64 funds (out of 84 funds reviewed) are reported to have agreed to compensate investors a total of £34m and to change their marketing materials.

The FCA has not named the funds or fund managers involved and has not revealed how it has determined either that 20 funds out of 84 should be excused compensation or that 64 should be included. As matters stand, no naming or shaming has yet taken place - so these “closet trackers” are still “in the closet” for now.

“Closet Tracker” timeline

Sept 2014 : Danish regulator says ⅓ of domestic equity funds could be ”closet trackers”

Dec 2014 : Swedish Shareholders’ Association “closet tracking” claim vs Swedbank ($840m)

Feb 2015 : Swedish regulator starts probe

Mar 2015 : Norwegian regulator intervention on pricing for DNB fund regarded as closet tracking

July 2015 : Swedbank claim dismissed

Feb 2016 : ESMA report concludes between 5% and 15% of UCITS funds “could be closet trackers” but declines to identify potential closet trackers

From Feb 2016 : National regulators prompted by ESMA into investigations including by BaFIN (Germany), Consob (Italy), AFM (France) and AFM (Holland)

Feb 2017 : Better Finance uses ESMA criteria to identify potential “closet trackers” identifying 165 UCITs funds by name as potential closet trackers

Mar 2017 : French regulator concludes it does not consider French funds brought to its attention to be “closet trackers”

Jun 2017 : FCA cites “closet trackers” as not providing “value for money”

Jan 2018 : Norwegian class action vs DNB Asset Management dismissed

Mar 2018 : FCA announces £34m informal compensation scheme

The news has attracted comments about the potential for this to be “the asset management’s PPI moment”. The litigation funding industry has repeated some high level maths as to the amount of fees potentially overcharged and experienced a frisson of (premature) excitement.

Few in the industry will have sympathy for asset managers who have misled investors and overcharged them for the privilege. This though is an area ripe for overreaction - some of which we are now seeing. Having followed this issue for some time and anticipated the potential for the relatively new claimant industry in the UK to latch onto an opportunity, we set out below a summary of what we see as the key issues.

Context is, as always, important. The “closet tracker” issue has formed part of the subject matter for the FCA’s Asset Management Market Study. The outcome of the consultation resulting from that study is anticipated this month. So the announcement of the unofficial redress scheme comes as part of the FCA’s warm up for an agenda for the Asset Management industry in the UK over the next few years. That agenda is expected to include new requirements aimed at focusing asset managers on the issue of providing “Value for Money”.

Another context factor is that we are (possibly) near the end of a period of steadily rising equity markets with most indices and benchmarks having been sustained in part by post-credit crisis economic policies (including quantitative easing). Rapid growth in passive investment means investors have enjoyed the returns from rising indices tracked at low cost. Over the same period active managers in aggregate are said by some (though others disagree) to have failed to justify their higher costs, such that, with hindsight (and on balance), investors’ better option over the last near-decade would have been to track indices and look for the most cost effective way of doing so. That does not, of course, mean the same will be true over the next decade, six months and even ten days. The well understood risk remains that when benchmarks do go over the edge, everyone tracking them will go over with them.”

A further point on context. Not so very long ago, active management was subject to a spate of investor claims (some more public than others and the highest profile being a claim brought by the Unilever Superannuation Fund against what was then Mercury Asset Management - see "Flashback to 1999"). The claims resulted from actively managed portfolios being said to be too different to the benchmarks against which their performance was to be measured. The lesson learned at that time was that if you are trying to outperform a benchmark by 1% or 1.5% per annum, a combination of hindsight and deviating too far from that benchmark risked exposing the manager to criticism and claims for being overly “active”. Today’s issue is the other side of the same coin.

Flashback to 1999 - the issue in reverse

The Unilever Superannuation Fund (USF) brought High Court proceedings against what was then Mercury Asset Management alleging the UK portfolio within its balanced mandate had been mismanaged by reason of excessive deviation from the benchmark applicable to the UK equity portfolio.

At the time Mercury had marketed its concentrated style - holding as few as 40 stocks from the UK benchmark (FTSE All Share).

At a whole portfolio level the USF performance objective was:

“To produce a return of 1% per annum in excess of benchmark, net of fees, over periods since inception…. The return will be expected to be no more than 3% below benchmark in any period of four successive calendar quarters.”

The claim alleged that applying both limbs of that objective to the UK portfolio, the degree of risk relative to the UK benchmark was too great. The manager explained underweighting parts of the benchmark believed to be overvalued. The USF argued that the performance objective did not afford the manager that degree of discretion and required less deviation from the benchmark.

The case settled mid-trial following the start of expert evidence. Following the settlement similar cases were brought and settled.

A lesson for active managers at that time was that active managers with benchmark relative performance objectives took on litigation risk if they strayed too far from the benchmarks and underperformed.

What has the FCA done so far?

In its June 2017 Final Report on its Asset Management Market Study, the FCA concluded there was weak price competition in a number of areas of the asset management industry and criticised how asset managers in general communicated their objectives and identified a general lack of transparency.

Under the heading “Value for Money” the FCA referenced respondents citing “closet trackers” as one area where the asset management industry was not delivering value for money. The FCA found no clear relationship between price and performance and found that many active funds offered similar exposure to passive funds. The FCA estimated there was around £109 billion AUM "in active funds that closely mirror the market which are significantly more expensive than passive funds”.

Without prior warning, and via the Sunday Telegraph (rather than its own website and its usual lines of communication), the FCA revealed that following a review of 84 potential "closet tracker" funds, 64 funds had agreed to compensate investors a total of £34m and to change their marketing material. One asset manager with “very misleading” marketing material faces a more detailed enforcement investigation.

An informal and anonymous compensation scheme is, of course, quite different to an FCA Enforcement outcome. At the level of anonymous compensation in this case (£34m across 64 funds averages just over £0.5m per fund) it is apparent that even a manager who believed it had done little wrong might agree to contribute rather than face enforcement action, financial penalties and the publicity that might attract.

What is the closet tracking issue?

Active managers charge higher fees for making judgement calls based on research and analysis with a view to generating a return in excess of a benchmark. Trackers charge lower fees because their job is to track an index as closely as they can, which does not require making equivalent judgement calls or the investment in the same kind of research and analysis. “Closet tracking” is the name being given to active managers who charge investors the premium associated with active management but whose portfolios, on analysis, are very similar to those of a lower cost tracker fund.

Why is the FCA concerned?

The FCA is concerned that normal competitive market pressures are not operating in the asset management sector because investors are insufficiently informed or motivated to spot when they are being sold a product normally associated with justifying a higher fee, when in fact they are receiving a product which they could obtain more cheaply elsewhere. In aggregate the FCA is concerned that a slice of the investor community’s wealth (much needed by an aging society) is benefitting asset managers who are effectively overcharging investors for what they are delivering. By addressing that issue, the FCA is looking to improve the attractiveness to investors of a sector perceived to be vital to the UK economy and to ensure a slice of investor wealth is preserved for investors likely to need it.

Is there a definition of “closet tracking”?

There is no recognised definition. That is part of the issue. It may be that in distinguishing 20 of the 84 funds the FCA reviewed (and deciding no redress was in fact appropriate) the FCA has applied some form of “closet tracking” criteria. If so, that has not been published. Alternatively (and more likely) the FCA may have focused not so much on how the funds were managed, but on how they were managed in practice relative to how they had been marketed and sold. That is an easier issue to assess against the existing financial promotions regime.

ESMA says it has been looking at closet tracking since 2014. It came up with criteria it regarded as indicative of potential closet tracking in 2016. Based on those criteria (and sampling undertaken in 2012-2014) ESMA assessed that somewhere between 5% and 15% of retail equity funds across Europe “could potentially be closet trackers”. It is those figures that attracted particular attention from litigation funders. One litigation funder (said to be working on a closet tracking legal action) projects that overcharging across the industry might amount to £6.6bn per annum.

While there is no definition of “closet tracking”, there are measures (see Measures of “Closet Tracking”) used by the industry. The effectiveness of those measures for identifying "closet tracking" is the subject of significant debate. Clearer are the requirements with respect to informing investors how investments will be managed. So, for example, Article 7.1(d) UCITS KIID regulation 583/10 requires investors to be informed whether the investment approach includes or implies reference to a benchmark, and, if so, which one and the “degree of freedom available in relation to this benchmark”. Article 7.1(d) goes on to state that where the UCITS has an index tracking objective, this should be stated.

Measures of “Closet Tracking”

Active share - the percentage of a portfolio that does not coincide with the underlying benchmark

Tracking error (ex-post) - the difference between the return of the fund and the return of its benchmark

ESMA classified as potential closet trackers funds with an Active Share of less than 60% and a tracking error of less than 4% (dropping to 50% and 3% in Member States with small equity markets)

R2 ratio - the % of fund performance that can be explained by benchmark performance

Tracking error (ex-ante) - projected anticipated diversion of the return of the fund from the return of the benchmark

There is no clear definition - what exists are different quantitive measures (each with limitations in isolation) which assist in assessing portfolio construction and performance relative to a benchmark. Broadly these measures are already used by many managers and some are incorporated into the descriptions of how funds and portfolios will be managed.

Most definitions used to identify closet trackers appear likely to be capable of credible criticism.

What have other regulators done?

Although facing criticisms in some quarters for inactivity, the FCA appears to be the first regulator to take steps to require financial redress (even if via an informal scheme) and launch a formal enforcement investigation.

As shown on the “Closet Tracker” timeline a number of European regulators have investigated the “closet tracker” issue since 2014, in many cases prompted by ESMA and its study resulting in a statement on “Supervisory work on potential closet index tracking” on 2 February 2016. Since that time, some regulators, such as the AMF in France, have stated they have looked at the issue and not identified a problem. While some regulators have given guidance on pricing, others, such as the BaFIN have stated they are unpersuaded that it was its job as regulator to influence the level of fees charged by German funds or intervene in the economic decisions of the regulated funds. In the UK, with the proposed (and expected) new focus on “Value for Money” the FCA will be taking a very different approach (see The FCA’s Value for Money Proposals).

Practical steps to help address concerns?

The current focus on the “closet tracking” issue will attract attention from investors and also from fund boards asking questions of their managers. The recent attention can certainly be expected to attract inquiries and also complaints. It can also be anticipated that the claims industry will be looking to organise action groups and to co-ordinate efforts to secure redress.

Funds that have out-performed their benchmarks by more than, or close to, their costs (even if they may have not met out-performance targets) are in practice unlikely to have any issue even if, technically, there might be scope for criticism that they have not been managed ambitiously enough.

Funds managed consistently with their performance and investment objectives and with their marketing material are unlikely to have an issue, even if they may have under-performed. Also funds that have materially under-performed (though they may have other issues) should be protected from the accusation of closet tracking to the extent that the underperformance is investment driven.

The funds which may attract the most attention are those marketed as “actively” managed but where performance has, on a consistent basis, been close to (but under) benchmark and where the approach to portfolio construction means that in practice the prospects of outperformance justifying the “active” fee are low enough to give rise to cause for concern that the fund has not been fairly and accurately described to investors.

Complaints and inquiries will need to be consistently and intelligently addressed. With the new focus on transparency and “Value for Money” some changes to fund names and descriptions may be appropriate, but need not necessarily be equated with past failings or as admissions.

In some cases name changes may be worth considering. Some have already been made.


For many years active managers have managed funds relative to benchmarks seeking to outperform those benchmarks. To that extent, many have been expected to track benchmarks to a significant degree, and the experiences of the late 1990s and early 2000s when claims were threatened and made based on perceived over-divergence made that clear. So a degree of “closet tracking” has been expected, even required. At the same time if funds are seeking to outperform a benchmark they cannot, consistent with such a mandate, simply hold the benchmark. That is not a controversial proposition. Even so, "closet tracking" is not a distinct issue to the existing (and soon to be strengthened) obligations to fairly and clearly inform investors how a fund will be managed and to manage the fund consistently with how it has been sold and described. That, one suspects, will prove to be the key driver behind the selection of FCA’s 64 unnamed funds making redress. What happens next at a regulatory level is anticipated to be the addition of “Value of Money” obligations on asset managers further to the FCA’s Asset Management Market Study and at least one enforcement action making an example of a fund where investors have received misleading descriptions of fund suggesting it would be more actively managed than proved to be the case.

The "closet tracking" issue is as a regulatory reference point an effective way of focussing attention on the fair and accurate communication of objectives and on transparency and linking those issues to the concept of value for money. For sure there will be some funds whose packaging has oversold the product. Even so, once hindsight is excluded, “closet tracking” seems unlikely to be asset management’s PPI moment, and it appears most regulators, having looked at the issue in more detail, agree.

The FCA’s “Value for Money” Proposals

The FCA proposes a “strengthened duty to act in the best interests of investors”.

The strengthening component is proposed to be achieved by clarification of existing duties, including the clients’ best interests rules and in governance changes.

A “new value for money rule” is proposed requiring the manager to assess whether value of money has been provided to fund investors (proposed New COLL 6.6.20).

The FCA also proposes governance changes including a prescribed responsibility under SM&CR for value for money assessments and minimum requirements for independent directors on certain asset manager boards.

This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.