Multi-managers seek to avoid inadvertently buying closet trackers that can damage their longer term returns. But do they spot them? There are in fact several techniques to avoid paying active fees for passive approaches.
Nick Watson, multi-asset fund manager at Janus Henderson, said investors wanted the right asset allocation calls and high-quality managers who could outperform their asset classes. ‘We have a long track record of identifying alpha generating managers. So buying a closet tracker takes away this second leg of returns and detracts from client outcomes,’ he said.
Watson believes the perils of closet trackers have been masked by quantitative easing, which has supercharged the performance of many assets. ‘Active managers historically struggle to keep up with a raging bull market, in this case driven by massive artificial stimulus,’ he said.
Watson considers factors such as active share, the number of holdings, volatility and historic tracking error to gauge whether a fund is run close to the benchmark or index. He prefers portfolio managers who have a clear understanding of their approach and a realistic appraisal of the issues facing their style. ‘Nimble, growing portfolios with ambitious fund managers trying to build their track records can offer differentiated return profiles that we can support,’ he said.
Investec UK Equity Income, managed by Blake Hutchins, is a fund he invested in early because of its emphasis on quality cash generating companies, such as Unilever and Diageo. ‘The portfolio looks and performs very differently from its peers and the FTSE All Share index,’ said Watson.
Nathan Sweeney, senior investment manager at Architas and co-manager of various multi-manager funds, is also on the lookout for closet trackers as the fees involved mean they underperform. ‘Poor performance over multiple time periods will put the fund on the sell list,’ he said.
Sweeney looks to see how a fund is marketed. If the focus is more on a team approach, it is likely to be run closer to the benchmark. ‘If you have an individual star manager on the fund, they will have a lot more autonomy over the portfolio, make higher conviction bets, and deviate more from sectors,’ he said.
Sweeney classifies funds into three buckets: core funds, high conviction and absolute return. ‘Core funds have tracking error of up to 4%, so anything over that is high conviction,’ he explained. ‘If a fund is classed as “go anywhere” it will be in the absolute return bucket.’
Therefore, he will consider metrics such as tracking error, beta and active share, as well as establishing how returns are being generated. ‘With core funds, a lot of performance is driven by sector allocation. With high conviction funds, it’s more down to stock selection,’ he said.
Into the mix
Closet trackers can also adversely affect portfolio construction, according to Cameron Falconer, multi-manager research analyst at Aviva Investors. ‘We often blend together complementary investment styles. Closet indexers have the potential to hinder this balance and skew risk in an unintended direction,’ he said. ‘This can often lead to unwanted factor exposures.’
Value for money is a key component of his fund selection process. Part of that is managers being paid based on the amount of alpha they are expected to generate.
‘It never ceases to amaze me how many funds out there charge excessively high fees, yet provide returns that are consistently similar to the benchmark,’ he said.
Falconer said enhanced index products may be chosen for smaller risk budgets. These come with lower fees than closet trackers. ‘Most of what we do revolves around selecting high-conviction, differentiated strategies with the potential for strong performance, while ensuring the manager receives compensation that is fair,’ Falconer said.