In this article we provide more detail on the circumstances and reasoning underlying the Court of Appeal's decision reported upon in an earlier article.
In our update on closet-tracking - “Where is the balance?” we commented on an 08 May 2019 Norwegian Court of Appeal ruling allowing 180,000 investors to recover excessive fees (£30.4m) charged for an actively managed fund, because the product delivered was tracking its benchmark more closely than investors were entitled to expect.
Having obtained an unofficial translation of the Court of Appeal’s judgment, in this article we provide more detail on the circumstances and reasoning underlying the decision. The quotations in this article are in unofficial translation only.
The claim was brought by unit holders in a UCITS fund, DNB Norge IV with the support of the Norwegian Consumer Council against the fund’s managers (DNB Asset Management). Fund management in Norway is regulated by statute (Securities Funds Act 2011) and by the Financial Supervisory Authority of Norway.
The Fund, its objectives and investment strategy
The fund objective was “to achieve the highest possible relative return”. “Relative” return was taken to mean excess (or active) return over the benchmark. The benchmark was the Oslo Stock Exchange’s Main Index (OSEBX).
The investment strategy identified security selection (alpha management) within sectors and asset allocation between sectors as drivers, with the fund mainly invested in Norwegian companies (but permitted to invest up to 20% in regulated markets generally) “through a well-defined and structured investment process, the management team analyses macro-economic trends, sectors and companies with the purpose of generating investment ideas that in general generate better returns than the benchmark index”.
The fund was expressed to be intended for unit holders with a savings horizon of at least 5 years and on a scale from 1 to 7 (where 1 was low return and risk and 7 was high return and risk) the fund was ranked “7”.
At the same time the investment strategy made clear that portfolio composition ‘’largely reflects the total market’’ and added ‘’the bulk of the funds are invested in a broad selection of leading companies listed on the Oslo Stock Exchange. The portfolio has a good distribution between companies and industries.’’
Looking at the investor information in aggregate the Court of Appeal took that information to mean “that the fund would be managed moderately actively compared to other actively managed funds” such that “its composition over time deviated to a not insignificant degree from the benchmark index.” In other words, the Court of Appeal thought investors could expect the fund to be managed actively, and more actively than most.
The overall management charge to investors was 1.8% p.a.. For comparative purposes the Court of Appeal proceeded on the basis that an equivalent index tracking fund would have cost 0.3% p.a.. So, for the product to be a success, the Court of Appeal referred to the degree of active management needing to aim for an active return 1.5% p.a. above the benchmark.
The case focussed on the period 1998 to 2014. Over that period the fund had averaged excess returns of 0.37% p.a.. Performance relative to the benchmark had fluctuated between periods of excess return and periods of negative returns as summarised below:
1998 - 2001
2001 - 2005
2006 - 2009
2010 - 2013
For comparative purposes the Court of Appeal noted evidence that Norwegian funds (as distinct from Nordic, European and global funds) had averaged an excess return of 0.80% in the period 1998-2017.
The applicable regulatory rules required the fund to be managed in line with good business conduct, of which pricing was determined to be an important factor. The Court of Appeal, could not, however, identify any reference points in terms of regulatory or industry standards or investor information which required particular levels or measures of active management.
It was clear, and common ground, that something more than passive tracking was required, but how much more and how that “more” should be measured was disputed.
The Debate as to the Appropriate Measure of Active Management
The manager’s contention was that the best measure of active management was historical returns over time; the goal was to produce excess returns after costs and the manager was entitled to adjust its management according to what had historically worked to produce such excess returns; the manager was not required to deviate from the benchmark for the sake of deviation and a relevant factor was that the benchmark in question comprised relatively few dominant companies (ie it was not very diverse).
The unit holders' contention was that active management should be measured using a combination of active share and tracking error. The investors also put emphasis on the ability to invest outside the index (up to 20%).
On the basis of extensive expert evidence the Court of Appeal agreed with the unit holders, deciding that a fund’s return history was not necessarily a measure of active management because a highly active fund could still produce returns very close to the benchmark - for example because different highly active positions could off-set each other resulting in benchmark-correlated performance.
The Court of Appeal had regard to consensus in academic circles and regulatory authorities both in Norway and in Europe (including ESMA) that active share and tracking error in combination gave a good indication of the level of fund management activity. The Court of Appeal concluded that “active share and tracking error in combination provide a good indication of the degree of active management”.
ESMA criteria were referenced and applying those criteria to a small market (such as the Oslo Stock Exchange), the Court of Appeal agreed with the manager that the starting point for assessing whether there were indications that a fund might be a closet tracking fund, would be lower than ESMA’s suggested 50% active share criteria. The question was how much lower.
Expert calculations evidenced that the fund in question had an average active share of 12.38% and an average tracking error of 1.39%. Based on Morningstar data the evidence was that no other actively managed fund in the Norwegian market had an active share of under 20%, and there was only one other active fund with a tracking error of less than 2%.
There was also evidence that manager’s own internal guidelines contemplated tracking error of between 2 and 4% and the Court of Appeal noted that the mid-point of the range, 3%, was ESMA’s criterion for indicating a potential client tracker; well over the fund’s average. Additionally, the manager’s internal functions had picked up the fund’s “very low historical tracking error” and had noted (in Sept 2014) that it had funds which “may receive attention” given the increased focus on “active vs index management in relation to management fee charges”. So, some emphasis was placed on the fact that internal flags had been raised.
On the basis of the evidence, including the views of the Norwegian regulator, the Court of Appeal concluded that the management in practice had been insufficiently active and was, therefore, “deficient”. So, while unit holders could have expected the fund to be more actively managed than most, in practice it had been less actively managed than almost all.
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 - which would include Norway)
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
The remedy the Court of Appeal imposed was to effect a price reduction such that the management fees charged reflected the lower level of active management to which the fund was in fact subject.
The reference points for pricing included Morningstar data for Norway and Sweden and previous regulatory decisions. One previous regulatory decision referenced was a decision not to intervene and lower the management fee (from 2% p.a. to 1.5% p.a.) for a fund with an active share of 30% and a tracking error just above 2%.
In the event the Court of Appeal determined a reduction in the management fee from 1.8% p.a. to 1.0% p.a. was appropriate; equating to unit holders having paid 0.8% p.a. too much in management fees. So, while the gap between the fee in fact charged (1.8% p.a.) and the equivalent fee for a tracker fund (0.3% p.a.) was 1.5% p.a., the Court of Appeal determined the management fee for the degree of active management it had observed was somewhere in-between: 0.7% p.a. more than for an index tracker and 0.8% p.a. less than had in fact been charged. In addition, the Court of Appeal awarded unit holders an amount to reflect forfeited returns on the excess component of the fees they had been charged to compensate them for loss of use.
We have commented previously that in our view “closet tracking” is unlikely to prove to be “asset management’s PPI moment” as some commentators have anticipated. While few in the industry will have sympathy for asset managers who have misled investors and overcharged them for the privilege, we anticipate that regulatory enforcement and civil claims will be focussed on extreme cases.
The Norwegian Court of Appeal case, at one level does concern a more extreme case: a fund whose objectives and investment strategy to which it had committed were regarded as at the more active end of active (7 out of 7 on a scale from 1 to 7), but whose active share was lowest in class, meaning that the percentage of the fund that did not coincide with the benchmark was, on average, just 12.38%. Had it been 30%, the suggestion of the judgment is that there would not have been scope for a price adjustment.
At another level the case is, however, plainly not about a tracker fund masquerading as an active fund and charging a higher fee. Over time the fund had outperformed its benchmark – something a tracker cannot achieve. For sustained periods it had, even with low levels of active share and tracking error, outperformed its benchmark by nearly 2.5%. Rather the case was about whether, on average and over time, the manager had, in the implementation of its investment judgement, demonstrated a sufficiently active approach to justify its fee relative to the investor information provided.
The conclusion was that while the manager’s investment idea generation may have proved on average pretty good (an average hit rate of 51.4%, meaning the manager was right more often than it was wrong), those ideas had been implemented with too muted conviction given what investors had been led to understand the approach would be and the fee charged.
There was evidence before the court that if, based on the same idea generation, the manager had doubled its bets, excess returns would have been far greater (and the active share and tracking error higher). Of course a manager making bigger, but worse, bets would have underperformed significantly, but escaped the criticisms in this case.
On the logic of the judgment, had the same fee been charged but the investment approach been described in a way that reflected management in practice, then the scope for intervention on price would not have existed. To that extent the case is arguably primarily a case about transparency and the consistency of what is articulated to investors vs. reality. To the reader the investor information that appears to have contributed most to the manager’s fate (subject to potential appeal) was the reference to an objective of achieving the ‘’highest possible relative return’’.
Interestingly the Norwegian Court of Appeal’s decision is heavily influenced by the concepts of active share and tracking error whereas there has, in Europe, been commentary to the effect that those measure alone are not sufficient. Such commentary notes that the different quantative measures all have limitations in isolation but can be used in combination to assist in assessing portfolio construction and performance. In a European context the expectation based on current commentary would be that reference would also be had, for example, to R2 ratio (ie the % of fund performance that can be explained by benchmark performance).
Between 2006 and 2009 (using its approach and relatively low levels of active share and tracking error), the manager had produced an excess return averaging 2.47% p.a.. Had, in 2009, a complaint been brought that the manager was taking too little risk and should either double its bets or halve its fee, the defence that the resulting performance justified the management approach would likely have been more difficult to resist. Had the manager doubled its bets in response to such a complaint, then the relative under-performance it saw in 2010 to 2013 (negative 1.37% p.a. on average) would then have been far greater.
The manager’s undoing in this case looks like it was neither lack of skill, nor underperformance; it was in the mismatch between aspects of its investor information and its management in practice viewed, not through the prism of performance, but the prisms of relative pricing and two measures of activity that did not (at least not expressly) feature anywhere in its investor information; active share and tracking error. The manager was also undone (subject to potential appeal) by being at two extremes; having an objective expressed in terms of “highest possible relative return” and levels of active share and tracking error which were lowest in class.
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