We use the FE Analytics tool a lot within PortfolioMetrix and recently whilst using it I thought it would be interesting to compare the performance of a very popular and well known Life company Multi-Asset fund which labels itself as actively managed versus a pure a passive developed markets equity UCITS fund (after costs) – Just how active is this active fund?
What I found appears to be a good example of ‘closet indexing’. Fund A (Green Line) is the Life Co Active Multi Asset Fund. Fund B (Purple line) is the UCITS Passive fund.
Closet indexing is the practice of staying close to the benchmark index while claiming to be an active manager and usually also charging management fees similar to those of truly active managers.
In Active management, active returns, or alpha, can only come about if your manager holds positions different to that of their benchmark.
Since active funds are more expensive than passive index tracking funds, it makes sense to check that the active fund you’re paying for is actually holding positions different from the benchmark and isn’t just a closet indexer.
In a study of active managers (Cremers and Patajisto, 2009), Closet indexers, as one might expect, were found to deliver at benchmark returns before fees but once fees are taken into account they underperform their benchmark. The worrying part of the researcher’s findings is that about one third of the managers analysed were in fact closet indexers (Petajisto,2010). Investors in these funds were therefore paying high active management costs for a portfolio that wasn’t truly actively managed.
If one is able to distinguish between those managers that are truly active and those that are not, one can significantly reduce the manager universe out there and focus directly on managers that are more likely to add value.
This is important in focussing ones attention when building a portfolio as opposed to following a “needle in the haystack” approach. Besides this fact it only seems fair that investors should get what they pay for i.e. actually receive true active management for the more expensive active management costs being paid.
This highlights the importance of proper due diligence when selecting funds for clients and raises further questions around the opacity of some of the investment options out there on the market.