How Not to Police Mutual Funds

Bloomberg View highlights research by finance Professor Martijn Cremers.

A Swedish class-action claim threatens to change the face of the mutual fund industry, in Europe at first and then, perhaps, globally. If the Swedish Shareholder Association succeeds in its complaint, it will get harder for funds to charge high fees for active management while actually closely following their benchmark indexes.

The practice is known as closet tracking, or index hugging. That’s what 3,000 Swedbank Robur clients accuse the asset management subsidiary of the country’s biggest bank of doing. Their 7 billion Swedish krona ($820 million) claim has been filed with Sweden’s National Board for Consumer Disputes. Swedbank says if the clients win, it may countersue in a court of law.

That might be unpleasant for the plaintiffs, but it would be useful for the industry as a whole: the Swedbank Robur case could set a precedent for dealing with funds that say they manage their clients’ money actively, but in reality opt for safer, less costly tactics, while pocketing fees that are twice to five times as high as those for funds that advertise themselves as index-tied.

Work by the Nobel prizewinning economist Eugene Fama and his collaborator Kenneth French has convinced many market professionals and sophisticated investors than in competitive markets, stock picking makes little sense, because on average, index funds outperform actively managed ones. That discovery has spurred growth in the passive fund industry. The share of assets held in such funds worldwide increased to 22 percent in 2010, from 14 percent in 2002, according to a 2013 paper by Martijn Cremers of the University of Notre Dame. Still, most clients still invest in funds that say they’re trying to beat their benchmarks.

I’ve run mutual funds sales teams and I know fund managers and salespeople often see that as ignorant obstinacy. They believe funds do their clients a favor by tracking an index. And as for the fees, well, the choice is up to the clients.

The problem with that approach is that the conventional wisdom concerning index funds’ outperformance is an oversimplification. Cremers and his collaborators found that truly active funds tend to outperform their benchmarks, and active share — the difference in holdings from the index — is an accurate predictor of better returns. It’s the closet indexers that mess up the statistics, leading to the false conclusion that going with the index is an investor’s best bet.

Moreover, Diane Del Guercio and Jonathan Reuter found in 2011 that actively managed funds were more likely to outperform the benchmark when the funds were marketed directly to investors, than when they were sold through brokers. Directly sold funds attract, and lose, investors in line with their performance, which gives them an incentive to hire more skilled analysts and invest in research. Broker-sold funds, such as those you can buy at your bank, have no such incentive; people who invest in them tend to trust the salesperson’s advice and then stay put. 

There is a case to be made for regulatory intervention to prevent people from being duped, especially in markets where there is less competition among asset managers. According to the Cremers paper, the share of assets held by closet trackers — funds where less than 60 percent of holdings differ from the index — is 15 percent in the U.S. and 30 percent in the rest of the world, which explains Europeans’ growing unease with the phenomenon.

Still, regulation risks creating more distorting behavior by less skillful fund managers, who will figure out ways to comply with any new requirements, while still hugging their benchmark indices and continuing to charge high fees. At the same time, it might become difficult for true active managers to “agree” with the index for a while, when they feel that’s warranted.

Regulations could also, perversely, expose consumers to more risk than they face now  — not necessarily a desirable outcome. “To the extent that closet trackers are seemingly being encouraged to deviate more from their benchmarks, the usefulness of the benchmark as a gauge of risk becomes less relevant or meaningful — with potentially detrimental results for consumers,” Jean Pierre Casey of the Center for European Policy Studies wrote in a December, 2014.

Courts and regulators such as the European Securities and Markets Authority, which is now studying possible approaches to the closet tracking problem, cannot resolve what is largely a financial literacy issue. The actively managed funds should do a better job explaining what makes them different from passive ones and why they charge higher fees. Gradually, investors will come to understand whether they want to play the stock pickers’ game for the very real possibility of higher returns — or go with a cheap index fund. 

Read this article on the Bloomberg View website.