Tips for Spotting Closet Trackers
Are you getting the active management you’re paying for?
To be fair, it’s not always the manager who’s to blame for such a state of affairs. At some firms, overly tight risk constraints can hamstring managers and give them very little leeway to follow their own convictions. But more often, the main risk that closet tracker managers are concerned with is paycheck risk. That is, the managers fear losing their jobs if they underperform their benchmark. To minimize the chances of that, some are content simply to deliver index-like performance.
So how can you tell if a fund is a closet tracker?
R-squared is a statistical measure that can help you ferret them out. It measures the proportion of a fund’s returns that can be explained by variations in the benchmark index. For example, if a fund has an r-squared of 79, that means that 79% of its returns can be explained by the fluctuations of its benchmark. A fund with an r-squared in the high 90s may likely be a closet tracker.
A close examination of a fund’s holdings can also give a tip off. If a fund has lots of its top holdings in common with its benchmark, it may be a closet tracker. For example, if a UK large-cap fund shares many of its top 20 holdings with the FTSE All Share, that could be a warning sign. A more detailed comparison of the fund’s portfolio with the index’s can shed more light on the situation.
If further research shows that the fund’s average market cap is similar to the benchmark’s and its sector and/or country weights are also in line with the index’s, you may be looking at a closet tracker. Granted, a few talented managers who operate under such constraints have been able to add value through adept stock picking, but they are few and far between.
In our analysis, when we see lots similarities between a fund portfolio and its benchmark, we ask the manager pointed questions about the top holdings. We want to get a sense that the manager has a justifiable investment case for those stocks. Believe it or not, we’ve had managers admit to us that the fund owns in particular stock just because it’s a big position in the index, even though he or she isn’t particularly impressed with its investment merits. That doesn’t inspire confidence and it shortchanges shareholders of the active management that they are paying for.
After all, investors turn to active funds in the hopes of earning market-beating returns. But active managers face an uphill battle. Consider that almost 60% of active UK large-blend funds have failed to beat Fidelity MoneyBuilder UK Index, our favorite FTSE All Share tracker. The odds of beating a low-cost tracker are even lower for a fund that is shackled to its benchmark. Why pay up for a fund like that?
