In recent years the European regulatory dialogue on costs and charges within products has been focused on enhanced disclosure. However, an increasing number of regulators, within Europe and beyond, are now asking questions about whether the level of fund management charges is reasonable.
The recent European Securities and Markets Authority (ESMA) report on potential closet index tracking funds is the latest example of this trend. It found that 5 percent to 15 percent of European Union (EU) actively managed funds may potentially be 'closet index trackers'. The baton has been passed to the national regulators to investigate further.
‘Closet indexing’ in funds is described as the practice of managers claiming, according to their fund rules and investor information documentation, that they manage a fund in an active manner and are charging a management fee in line with funds that are actively managed, while the fund in fact stays very close to a benchmark, which indicates an investment strategy requiring less input from the investment manager.
ESMA notes that many EU Member States have launched or are in the process of launching specific investigations to determine the potential extent of closet indexing in their jurisdictions, with a focus on equity funds at this stage. This statement reveals that more Member States have yet to make public the fact of their investigations, as only a handful have done so to date.
ESMA further notes that managers should expect supervisory consequences where evidence for incorrect disclosures is proven. It also, though, suggests that investors should make use of all available documentation when taking an investment decision and that, although past performance is not a reliable guide to future returns, ‘there may be value in assessing whether a fund has been able to achieve the objectives referred to in the fund documentation’. The authority may wish to reflect on this statement as it finalizes the rules for the Packaged Retail Investment Products (PRIIP) key information document (KID) – the Undertakings for Collective Investment in Transerable Securities
(UCITS) key investor information document (KIID) includes past performance, but under current proposals the PRIIP KID will not.
The industry needs to take seriously the allegations of closet indexing. Firms need to demonstrate that they are acting unambiguously in the interests of investors, including in the setting of the management fee charged and ensuring they do what they say on the tin.