Closet Indexers Beware: Regulators Are Watching You

Authorities in Europe have turned their attention to funds that track the index while charging active management fees.


Since the 2008–’09 financial crisis, U.K. asset manager SCM Direct has been calling for a name-and-shame campaign against closet index funds. Such funds purport to be actively managed, but they hug their benchmarks so closely that returns often track the market, leaving investors with a high-priced index product. As investors and regulators demand more transparency, managers with a limited active share in their funds may see enforcement actions.

“In today’s investment landscape it is increasingly difficult to beat the market on a repeatable basis,” says SCM founding partner Gina Miller. “Active management is a dream, and these funds have been selling snake oil for far too long.”

The financial crisis prompted SCM to investigate the underlying holdings of several retail funds to which it had exposure. But the task was daunting, Miller recalls: U.K. regulations require mutual funds only to reveal their top-ten holdings.

In Sweden, national shareholders’ association Sveriges Aktiesparares Riksförbund sued Swedbank Robur, the country’s largest bank, after it admitted to hugging the index so closely with some products that their chances of success were extremely low. That landmark class action suit, which included 3,000 investors, was dismissed last July. Still, Swedish regulator Finansinspektionen (FI) released a consumer protection report that includes a plan for tightening regulation of closet indexers. FI found evidence of funds being marketed as active but exhibiting the kind of ultralow tracking errors common among index products.

The difference in fees between an actively managed fund and an index fund in Sweden is often no more than a single basis point, but over time those costs add up. Erik Lindholm, Stockholm-based deputy director of consumer protection supervision at FI, says vague language in some fund directives may be part of the problem. The Undertakings for Collective Investment in Transferable Securities (UCITS) directive clearly defines an index fund, Lindholm notes. “But that’s not the case with an actively managed fund,” he says. “The definition for that is broader, and so you can have funds with very limited active share that still market themselves as an active fund.”

Regulators in Denmark and Norway are also scrutinizing potential closet indexers. In early February all of this attention culminated in a bulletin from the European Securities and Markets Authority (ESMA) alleging that index hugging is widespread among European collective investment funds. ESMA examined roughly 2,600 funds active from 2012 to 2014; initial research suggests that between 5 and 15 percent of them were tracking the market.


“We will also be considering whether market conditions would dictate a more passive stance on behalf of the fund in order to stay within its mandates,” says ESMA spokeswoman Catherine Sutcliffe. “But we felt confident after our preliminary research to say that even with that there were funds engaging in this practice.”

Asked if the initial investigation was enough to warrant new disclosure rules, Sutcliffe says that’s the next step: “We are going to be taking a close look at the disclosures to make sure that they are as rigorous as they need to be.”

SCM’s Miller is calling for disclosure similar to Form 13-F in the U.S., which reveals all positions in a given fund on a quarterly basis. “It doesn’t have to be quarterly; it could be every six months,” she says. “But the broader point is that people should know what they’re investing in for the money.”

Closet indexing isn’t only a problem in the European Union. Last November, Morningstar released a report estimating that Canada has the largest number of what it believes to be closet index funds. Depending on the time frame, as many as 75 to 85 percent of the so-called actively managed vehicles that Chicago-based Morningstar studied in its report performed no better than index funds.

Fees for Canadian actively managed funds vary, but they’re higher than Sweden’s 1 percent. Although local investors don’t like closet indexing, so far the provincial regulators that oversee the country’s investment industry haven’t acted. Surprisingly, the Ontario Securities Commission’s 2015 annual report on mutual fund fees and flows doesn’t mention index hugging.

Meanwhile, the practice is raising the hackles of active managers who have to compete against large index replicators. William Ackman, founder and CEO of New York–based Pershing Square Capital Management, used much of his investor letter for the fourth quarter of 2015 to discuss how the “index-fund bubble” impacts stock prices. The hedge fund manager argued that as more index funds pile into the stocks that anchor the benchmark, they inflate them relative to stocks outside the benchmark, for no reason other than crowding. When active managers buy stocks that aren’t in these crowded trades, they become outliers and can face pressure from investors to pile back into the index with everyone else.

Critics accused Ackman of using the letter to explain away poor performance: Pershing Square Holdings, his fund’s publicly traded vehicle, suffered its worst-ever year in 2015, falling 20.5 percent, and was down about 15 percent as of January.

But others conceded that he had a point, given that billions of dollars in assets are tied up in liquid funds that do little more than track the index. The Securities and Exchange Commission recently said that it will look more closely at how these funds are marketed as part of a broader push to examine registered investment advisers, which typically offer a mix of active and passive liquid strategies.

All of this stops just short of enforcement, but regulators are starting to open the door on closet indexers.

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