Investors are being urged to look at funds’ ‘active share’ alongside other measures when assessing their potential for outperformance following research claiming fund managers are swindling people out of fees.

Active share was defined by Yale Professors Martijn Cremers and Antti Petajisto in 2009 as ‘the fraction of a portfolio or fund that is invested differently from its benchmark’.

It’s becoming a widely-held belief that if less than 60% of a fund’s holdings are different from the index it’s a ‘closet tracker’ which charges high active management fees despite doing very little active fund management.

The Financial Conduct Authority recently indicated it could begin an inquiry into closet trackers after the Swedish government announced it will formally investigate the practice, which is particularly prevalent in pensions. This follows a report by SCM Direct which found 36% of UK active funds are ‘no more than expensive copies of index funds’.

‘The British public may have been swindled out of approximately £803 million in 2014 alone through insidious closet tracking practices,’ SCM says.

According to Premier Asset Management, investors are paying an average annual ongoing charge of 1.43% for closet trackers, well above the 0.61% paid by tracker holders and only fractionally below the 1.55% paid for the market’s most active funds.

Simon Evan-Cook, senior investment manager for multi-asset funds at Premier, says holders of closet trackers receive worse results than holders of cheap index trackers mainly because of the higher charges they pay. Closet trackers also drag down the performance of the average active fund because they are classed as fully active in statistical studies.

‘UK equity closet trackers have underperformed cheap, genuine trackers by 0.3% a year over the current market cycle, but have lagged highly active funds by 2.9% a year,’ says Evan-Cook.

Underperformers

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The three funds with the lowest active share in SCM Direct’s report are Halifax UK Growth C (GB0031810210), Scottish Widows UK Growth A (GB0031632234) and Santander PF UK Equity A (GB0002795101) with active shares of 18.5%, 21.4% and 27.6% respectively. They all underperformed the UK market in 2014.

A spokesperson for Lloyds Banking Group says the Halifax and Scottish Widows UK growth funds are primarily used as the UK equity component of its multi-asset funds, which offer other elements of active management. ‘The cost of our funds relates to the broader proposition, rather than being an unbundled charge alone,’ he says.

M&S Bank, whose Marks & Spencer UK Selection Inc’s (GB0005652192) active share has been calculated as 39.5%, argues its 1.62% ongoing charge is the total cost to customers and there are no additional transactional, holding or platform charges. It says the fund is competitively priced compared with other actively managed funds and has outperformed its benchmark four times in the last five years.

‘80% is actively managed by two separate fund managers. The first looks to add value by investing in long-term growth stocks which are trading at attractive valuations (40% of fund). The second focuses on companies with consistently high profitability, little debt and good cash generation, preferring companies with established franchises that deliver sustainable organic growth (40% of fund),’ an M&S Bank spokesperson says.

NFU Mutual and JP Morgan Asset Management, which have funds with an active share of 39.6% and 42.2% respectively, say they hold a significant proportion of large cap stocks which contributes to the lower than average active share. Ian Butler, fund manager for the JPM UK Strategic Equity Fund (GB00B235SZ61), whose top three holdings are Royal Dutch Shell (RDSB), HSBC (HSBA) and BP (BP.) says these mega cap names are attractive investment opportunities given their cheap valuations.

Transparency

The mounting pressure faced by fund managers over closet trackers is leading some to publicly declare their active share. Woodford Investment Management recently calculated the CF Woodford Equity Income Fund’s (GB00BLRZQC88) active share to be 81.37% which it revealed in a blog on its website. Neptune divulged the active share of each of its funds at the beginning of February - they range from 46.5% to 96% - and Threadneedle and Baillie Gifford plan to make similar disclosures soon. M&S Bank states its active share in its fund marketing material and factsheet.

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The fund management industry is notorious for having opaque charging structures so the more information that’s available to investors the better. But while the disclosure of active share is a positive step forward, it’s not the only factor to consider when choosing one fund over another.

‘If a fund has a 50% active share but has low fees then it isn’t necessarily a bad thing,’ says Evan-Cook. ‘If a fund pretends to be active but its active share is only 30% to 40% and it isn’t open about this there’s a very high chance it’s not good value for money. Knowing the active share is a good start but it isn’t the only factor.’

Laith Khalaf, senior analyst at Hargreaves Lansdown (HL.), goes further by saying it’s dangerous to use active share in isolation. ‘The idea that a fund with less than 60% active share is a closet tracker is bunkum. Active share does offer some insight into how a manager runs their fund, but it’s not a hard and fast indicator of the fund’s potential for outperformance.’

The point at which a fund’s active share gets so low that it can’t perform materially differently from the index will depend on the index in question, the period considered and the correlations between stocks in the index.

‘Unless you’re opting for an active fund manager who has a totally unconstrained mandate then there are inevitably going to be times when the fund manager is close to their benchmark,’ says Rebecca O’Keefe, head of investment at Interactive Investor. ‘Creating a simple rule which defines a closet tracker from an active fund is a fairly crude measure and may result in genuinely active managers being overlooked.’

SCM’s analysis shows several funds with less than 60% active share still outperformed the market in 2014. Franklin UK Equity Income A Inc (GB00B6VBM744) has an active share of 46.8% and it returned 6.1% in 2014 compared with the UK market’s return of 1.2%.

‘Investors choosing a fund have a number of things to consider, not least which platform to hold their funds on. However, if investors have elected to pay for active management then they should be looking for a fund manager who they know and trust and one where the increased level of risk taken is commensurate with the higher costs and potential for higher returns,’ says O’Keefe.