Further update on “closet tracking” - Where is the balance?

In this latest in a series of articles on “closet tracking” we update our closet tracker timeline, comment on new developments and look at the substantial remedial action now being taken by regulators.

In this latest in a series of articles on “closet tracking” we update our closet tracker timeline, comment on new developments since our update on 19 December 2018 and look at the substantial remedial action now being taken by European regulators with specific reference to ESMA’s latest position as set out in the Q&A on UCITS and the FCA’s position as highlighted in their policy statement, PS 19/4.

The background theme is that of improving transparency in response to new regulatory requirements, but mindful of the risk that those changes may be said to recognise a previous lack of transparency. Where is the balance?

New Developments

In our end of 2018 update we predicted that regulatory and investor scrutiny of “closet tracking” would intensify across Europe in 2019.

At that time (i) the FCA had sponsored a redress scheme and announced it was taking enforcement action in two cases; (ii) the French regulator, the Autorité des Marchés Financiers, had announced plans to investigate potential closet trackers; (iii) the Swedish government had proposed new disclosure rules; (iv) the Central Bank of Ireland had announced that it was looking at over 2,000 UCITS funds to check for closet trackers; and (v) ESMA had announced that it was looking to publish guidance in the form of a Q&A to clarify disclosure requirements in response to concerns that managers were failing to make disclosures about the use of benchmarks.

Regulatory Remediation for the Future

Matters have moved on: ESMA’s Q&A has been published seeking to promote a common supervisory approach. The FCA got in ahead of ESMA publishing PS 19/4, its policy statement on further remedies further to the Asset Management Market Study. Both remediation phase developments seek to tackle underlying issues believed to have contributed to investors not being sufficiently informed or discerning to ensure that they are not paying for active management (and the outperformance such management is intended to deliver), while receiving something less ambitious for which a lower fee would ordinarily be expected. The underlying issues which the FCA and ESMA are seeking to address centre on perceived lack of transparency around fund manager use of benchmarks for defining a fund’s investment strategy constructing a portfolio or measuring its performance.

PS19/4 sets out new requirements for authorised fund managers to include a statement in a UK authorised fund’s prospectus and other consumer facing documents on the choice and use of benchmarks. The FCA identifies three categories of benchmark, the choice and use of which must be disclosed to investors:

    (i)    Target benchmark - a benchmark used to define the fund’s target performance 
    (ii)   Constraining benchmark - a benchmark constraining the construction of the fund’s portfolio, and 
    (iii)  Comparator benchmark - a benchmark used to compare performance of the fund.

Where no benchmark is used the manager is required to include a statement in the prospectus and consumer facing communications explaining how investors can measure fund performance. These requirements came into force on 07 May 2019 and apply to all new funds authorised after that date. Documents in respect of existing funds will need to comply by 07 August 2019.

ESMA’s Q&A clarifies benchmark disclosure obligations for UCITS. This guidance states that each KIID (Key Investor Information Document) should indicate whether the relevant UCITS’ strategy is active or passive. For those UCITS which are active, they must disclose whether they are managed with reference to a benchmark and, if so, the degree of freedom the manager has relative to the benchmark. ESMA has given an indication of approaches that imply that a UCITS is being managed by reference to a benchmark. It has cast the net very wide, capturing, for example, instances where a manager has issued marketing material showing fund performance relative to a benchmark. ESMA have stated that they expect the universe of UCITS which are managed with no reference to a benchmark to be relatively small.

Both developments are intended to enable investors to better understand the use of benchmarks by a fund and therefore how a fund is ultimately managed. These developments, taken together with the requirement for authorised fund managers to conduct value assessments (which comes into force in September 2019), have in mind aligning charges with products and value delivered and giving investors information which will permit them to be more discerning. Once there is both improved transparency and reporting on value, the rationale is that charges going forward will more consistently reflect the service being provided, in part because competition should be encouraged. Planning for implementation in respect of existing funds is current (as illustrated below).


Risks as to the Past

Remediation for now and for the future is the main regulatory focus, but the question of potential accountability for the past lurks in the shadows. We have previously poured a measure of cold water on closet tracking having the potential to be “asset management’s PPI moment”. We remain of the that view. Even so, collective actions relating to closet tracking continue to attract attention and interest. So the remediation phase is rightly accompanied by the occasional look in the rear-view mirror.

In Norway, on 09 May 2019 an appeal court overturned the dismissal of a class action closet tracker case by a lower court. The appeal court found that the Norwegian banking group DNB’s asset management arm had overcharged around 180,000 investors in “closet tracker” funds and ordered it to pay a total of around NKr345m (£30.4m representing the difference between the management fees that were charged to investors for the funds in question and the fees that DNB charges for index funds. The decision reversed the findings of the Oslo City Court which, in January 2018, ruled in favour of DNB and dismissed the class action.

The Norwegian Consumer Council (Forbrukerradet), which had fought the case on behalf of an opt-out class of affected investors, claimed that three DNB funds were marketed as actively managed funds charged investors fees typically associated with active management, but did little more than track their benchmarks over a five-year period from 2010 to 2015. As part of its claim the claimant conducted analysis of active share, tracking error and R2 of the three funds (see Measures of “Closet Tracking” here). It was established that no other Norwegian equity fund marketed as actively managed had tracked the index as closely as the three in question. That fits with our expectation that it will be the more extreme cases which will attract enforcement action and litigation.

The Norwegian Consumer Council argued that the judgment could open the possibility of similar cases across the continent to “protect people’s savings and pensions from overcharging in the future”. Meanwhile, DNB claims that the funds’ investors received “what they were promised” and that a management team did actively select shares in which the funds invested. It is now considering whether to appeal the judgment to the country’s Supreme Court.

Meanwhile in Canada class actions have been initiated against managers of two funds on behalf of investors in the RBC Canadian Equity Fund and TD Canadian Equity Fund.

In each instance the plaintiff argues that the assets of the relevant fund (and mutual funds holding that fund) have been depleted by what are said to be excessive fees which were charged on the basis that the relevant fund was actively managed, as stated in the fund documentation, in circumstances where its “true” investment strategy was passive and designed to track, but not exceed, an index (ie a closet tracker).

Updated Closet Tracking “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)
June 2016

Norwegian Consumer Council brings class action in Oslo District Court on behalf of 180,000 unit holders

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, AMF, concludes it does not consider French funds brought to its attention to be “closet trackers”
June 2017 FCA cites “closet trackers” as not providing “value”. FCA Asset Management Final Report.
Jan 2018 Norwegian class action vs DNB Asset Management dismissed
Mar 2018 FCA announces £34m informal compensation scheme having identified 84 potential closet tracker funds. Two enforcement actions ongoing
Apr 2018 New York Attorney General publishes report following investigation of active funds
Oct 2018 AMF announces its plans to investigate potential closet trackers
Oct 2018 The Swedish government proposed new rules concerning disclosures relating to how a fund differs from the benchmark it has selected
Dec 2018 Central Bank of Ireland announces closet tracking analysis of 2,000 Irish domiciled UCITS funds
Feb 2019 FCA publishes PS19/4 setting out remedies to improve competition including a requirement for managers to disclose how and why they use benchmarks
Mar 2019 ESMA publishes its Q&A on the application of the UCITs Directive which requires prescribed information about how a fund is managed to be included in a KIID -applicable “as soon as practicable, or by the next KIID update”
Apr 2019 Class actions in British Columbia alleging pursuit of a closet indexing strategy in breach of representations and statutory duty
May 2019 DNB Asset management ordered to pay compensation of €35m following successful appeal in Norway
07 May 2019 FCA PS 19/4 applies to new funds
07 Aug 2019 FCA PS 19/4 will apply to existing funds
30 Sept 2019 FCA rules on value reporting will come into effect

New Duty revisited

In the background to interest in closet trackers, discussion in the UK about the potential to introduce a new duty of care to investors has been resurrected.

The FCA published its Feedback Statement FS19/2 on the subject in April 2019 which summarised responses to its July 2018 Discussion Paper and set out next steps. FS 19/2 revealed the FCA’s reluctance to ask Parliament to impose a statutory duty of care, which would require changes to primary legislation. That should not have come as a surprise; less than two years previously the FCA had concluded, as part of its Asset Management Market Study, that the benefits of a fiduciary duty could be achieved through regulatory reform and a focus on requirements to act in the best interests of investors without the need for a new duty.

Even so, the FCA now proposes to consider further whether it is necessary to revise and strengthen its Principles for Business, in particular Principle 6 - treating customers fairly - and introduce a private right of action for Principles breaches. The FCA proposes to publish a further paper this Autumn. The possibility of a statutory duty being recommended is not wholly off the table - but seems unlikely.


ESMA’s Q&A and the FCA’s PS 19/4 do not wholly overlap, but target closet tracking through addressing perceived underlying issues; in particular, transparency. ESMA’s Q&A targets KIIDs, FCA’s PS 19/4 targets fund prospectus and consumer-facing communications. In fact the FCA’s PS 19/4 is expressly not intended to apply to KIIDs. However, given the emphasis it places on consistency across all fund documents, in practice implementing PS 19/4 (by 07 August 2019) will inevitably impact KIIDs too. For UK UCITS ESMA’s Q&A and FCA’s PS 19/4 in practice need to be looked at as a package; albeit one in which not all the pieces are designed to fit together as neatly as if they had shared an author as well as a direction of travel.

New rules and requirements mean changes in how the management of existing funds will be described to investors. Investors and focus groups may of course ask whether such changes recognise a previous lack of transparency. In most cases the fact something has changed to reflect new requirements will not be any kind of recognition of previous failings - rather the bar is being raised. Making changes to meet new requirements cannot of itself be equated with failing to meet previous requirements. If that were true it would be an impediment to progress, which the FCA will wish to avoid. Even so the expectation is that in a minority of cases the fact and nature of the changes made will give rise to the potential for challenge.

Class action claims in the US (mainly mutual funds) and now in Canada are brought with emphasis on statutory duties for which, in the UK, we currently have no equivalent. If such a claim were to be brought by investors in the English Courts it would need to be brought on a different basis. The route in the UK for a private consumer (but not a business user) would be to identify a breach of a regulatory rule giving rise to a private right of action (most likely the client best interests rule). But the mood to continue to adjust the regulatory balance in favour of consumers remains. The next step looks like it may be towards the possibility of a private right of action for breach of regulatory Principles (rather than certain regulatory rules). Whether that step needs to be taken may well depend in part on whether multiple other regulatory changes (including those mentioned above and the extension of the Senior Managers and Certification Regime) are felt to be having the remedial impact intended.

Our sense is that in the UK, other than in the more extreme cases, the FCA’s focus will be on improving transparency going forward and that, therefore, the priority is on adhering to ESMA’s Q&A and FCA PS 19/4 and adopting new expectations going forward, not on the potential significance of any resulting changes as to the past. We expect the next round of potential FCA enforcement interest to follow implementation on 07 August 2019, and to focus on adherence to the new requirements.

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.