Question: What’s worse than putting your money into an active fund that charges high fees?

Answer: Putting your money into an active fund that charges high fees, but that to a large extent holds the same shares as its benchmark index.

Such funds are known as closet indexers, and a new report by wealth manager SCM Private claims that the UK is amok with these clone funds, compared to both the US and to investor expectations.

SCM’s research found 40% of the holdings of the average UK fund matched the underlying index, versus 25% in the US:

It says that nearly half of UK equity funds fall into this closet indexing category, compared to just 10% in the US:

Now given that most active funds fail to beat the market, you might cynically think the more of them who copy the index, the better.

But closet indexing is a poor deal for many reasons.

Firstly, if your fund largely mirrors an index, you’ve got even less chance of beating it. ¹

True, we have abundant evidence that the majority of active funds will fail to beat the market long-term, anyway. But closet indexers are even less likely to outperform. Presumably if you’re putting money into an active fund then that’s what you’re trying to do – so you want to pick a fund with the best shot at doing so.

Secondly, you’re paying a lot of money for less active management than you thought you were getting.

If you’re paying, say, a 2% management fee to a fund manager, but half of the fund is effectively an index tracker, that means at least 1.5% of your fee is effectively paying for the actively managed portion of the fund – which means you’re actually paying 3% for their active efforts! That’s a very high hurdle for their picks to get over every year before they can beat a cheap index tracker.

Thirdly, SCM says there may be miss-selling implications.

I think this is a stretch – if fund managers are allowed to implore you to put your money with them to beat the market even though so few do, it seems anything goes – but in the post-PPI climate, maybe they’re onto something.

Why do closet index trackers exist?

As you might have guessed from my pretty mild outrage, I’m not particularly aghast to learn that so many UK funds are closet index funds.

Perhaps that’s because I’ve known about the tendency for while, or maybe it’s because after so many years of financial scandal and drama, this one seems a village green sort of scam – more Bertie Wooster than Bernie Madoff.

SCM’s boffins worked out that under-performing closet index funds have cost investors £1.9 billion in fees in the past five years, which is admittedly quite a sum. And I do have sympathy for newbies to investing, to whom index tracking seems utterly illogical, whereas paying an expert to manage their money seems most prudent. They are being sold a pup.

But the great mass of the closet indexing money will be in the hands of experienced investors who’ve had plenty of time to wise up. Monevator alone has been making the case for cheap tracker funds for six or seven years!

Indeed, a big reason closet indexing exists is due to the unreasonable demands of investors.

I’m not defending the financial services industry, but it’s worth noting:

Investors are unrealistic. They want market beating funds, but they don’t buy into funds that have had a bad year. Perhaps they even pull their money out of them. This means under-performing the index – even for a short time – is a big risk for the typical fund.

Now beating the market over the long-term is extremely hard, but beating the market every year is impossible. Not even Warren Buffett has done that – he has lagged the index plenty of times. The odd losing year is the minimum price of trying to beat the market.

Of course the fund management industry encourages us to believe otherwise – provided we invest with their people who work harder, smarter, later, or more photogenically. So no tears for the industry. But it does explain closet indexing to a large degree.

Fund management companies have little incentive to risk failure. For massive firms it makes much more sense to try to keep investors broadly content in order to collect those hefty fees, than it does to try to shoot the lights out and risk an exodus of money if you fail.

Career risk is another reason for closet indexing. Even if a fund provider wants its managers to really try to beat the index, it will probably fire someone who lags the market by 5% quicker than someone who lags it by 2%, let alone a manager who delivers 1% either side for a few years. If you’re a well-paid fund manager, wouldn’t you play safe?

The rise of computers and modelling has made it simple to determine variables such as tracking error. This data may be used by sophisticated investment committees and trustees to determine where their money goes. A fund naturally wants its numbers to look good.

Finally, active managers aren’t stupid. On the contrary, they are smart. They have read the same stuff you and I have read about the difficulty of beating the market, and while they may have some behavioural quirks that allow them to feel they’re special, they’re not utterly deluded.

The fear that they are being asked to do the impossible must gnaw away at fund managers sometimes.

Do they really dare shun HSBC, when it makes up nearly 10% of the index? Do they dare ditch BP, or GlaxoSmithKline? Look at all the controversy Neil Woodford has gotten into for refusing to hold oil companies in his much-lauded income fund – and he’s a deity among UK investors.

Can you imagine a 28-year old fund manager in a big institution who is managing a large cap UK fund being able to justify an eclectic pick-and-mix approach to the FTSE 350? Maybe avoiding all banks and oil companies, but going heavy on smaller industrial firms? And justifying it not just to her own boss, but to repeated rounds of big investors?

They’ll say it can happen, but the evidence suggests otherwise.

Don’t be a clone drone

The bottom line is if you want a shot at returns from funds that are sustainably different from the index, you will need to dig deeper into each fund’s holdings to see what it’s invested in.

In an ideal world, funds would clearly publish their active share in the fund literature, so you could identify a closet indexer at a glance. But for now you’ll need to check with sites like Morningstar, or else work it out for yourself.

Of course the bottom BOTTOM line is you shouldn’t go down this road at all. Investing passively into tracker funds is simpler, cheaper, and more likely to deliver better returns over the long-term.

1. See H K.J. Martijn Cremers and Antti Petajisto of the Yale School of Management’s working paper: How Active Is Your Fund Manager? A New Measure That Predicts Performance.[↩]

For a brief moment I felt the joy of clearing my mortgage early. Now I have some explaining to do: because I’m not going to pay it off after all.

I have the opportunity. I own the full amount of my mortgage in cash and index trackers – split 50:50. The simple thing to do would be to flog off the trackers and hand over everything to the bank with a cheery: “Thanks for the loan, pin-stripes, you’ll never hear from me again!”

That would be simple. That would be safe.

It’s got a lot going for it.

But I can’t do it. Not with interest rates at an all-time low.

Interesting times

This feels like a historic opportunity to me. A chance to earn more by staying invested in the market over the next 10 years than I could gain by removing the mortgage-leech that’s latched onto my cash flow.

My assets currently yield double the amount I’m paying to service the debt. That alone stays my hand.

But this is a story about trading certainty for potential.

My current mortgage interest rate is 1.24%. ¹

The FCA is projecting nominal UK equity growth rates of 6.5% to 8% over the next 10 years. That would comfortably spank my tracker mortgage, as long as interest rates don’t go beserk.

Liquidating my equities now will deny me the potential for a decent return from the stock market for the next few years.

It would take several years to rebuild my position and I’ll always be saddled with the opportunity cost if the market marches on.

Yes, I could pocket the guarantee that my mortgage can’t get back off the floor like a B-movie baddie, but that comes at the expense of diversification. Most of my wealth would be concentrated into one, large, illiquid asset. With curtains.

And that asset comes with more baggage than the Sultan of Brunei. I suppose we could sell the house in the event of a crisis but the emotional fall-out would be huge.

Diverting cash or equities from the ‘mortgage jar’ would stick in the craw too, but at least I can do that in small chunks. It’s not like I can sell off the spare room to cover a period of unemployment. ²

So the plan is to keep building my cash holdings over the next seven to eight years until I eventually hold my entire mortgage balance in safe assets.

Meanwhile, the equities that are currently earmarked for the mortgage gradually move into the retirement jar as they are supplanted by cash.

I win if they bring home nominal growth that outstrips my mortgage interest rate.

What does disaster look like?

I’m taking a risk here, I’m not kidding myself. There’s a danger of trying to be too clever and The Investor has neatly stacked up the case for investing versus mortgage taming before.

But risk needs to be couched in personal terms, and for me disaster is a five-way car crash that looks like this:

• Losing my job.

• Losing my redundancy pay.

• Not finding another job.

• Ms Accumulator losing her job, too, and not finding another job.

• Interest rates rising like a Saturn V rocket while equity prices plummet like Beagle 2.

Now that would be a divine comedy roast with sauce, but I reckon the risk of it all happening at once is relatively low. (At least I’d make a few quid as a cautionary tale in the newspapers, I suppose.)

If equities dip then I’ll be back in the mortgage red but I’m happy to ride that out. I only really need the equity funds in a hurry if I can’t service my interest payments ³.

Of course, a serious crash is the bunkmate of mass unemployment so it’s worth noting that equities may offer scant protection just when I need them most.

If the scenario is soaring interest rates then I have a 50% cash cushion and a high savings rate to protect me.

As long as I remain in work, then I can always ease the pain by diverting monthly income not needed for essentials. That cash cushion should increase and I can always sell the equities if things get desperate.

Again, let’s acknowledge that equities are about as steadfast as a celebrity’s entourage once they can only get bookings at Butlins. The stock market is liable to be hammered when interest rates spiral so I could be forced to take agonising losses if things really go awry.

Is it worth it?

If I have seven years of bad luck and the markets decline then I’ll forever lambast myself: “You should have sold the trackers, paid the mortgage and invested future cash streams at ever cheaper prices.” Or words to that effect.

Psychologically I could rue this day for the rest of my life.

And there will be scares along the way. Scares that could last for months or years. I don’t think I’ll panic. I believe I’ll keep on paying down the mortgage like everyone else while waiting for equities to come back.

Still, you can’t be sure.

Lining up the negatives like this is another way of testing my resolve and I must admit the “No” camp looks strong.

Especially when you consider that any triumph is likely to be small in comparison to the potential for failure. That’s humans for you. Hardwired to hate loss more than we love gain.

But I don’t take many risks. This is one I understand and am well prepared for. The satisfaction of being mortgage-free is not as important to me as knowing I have the resolve to get there.

I can be patient a little longer because the real win is achieving financial independence as soon as possible. That’s something I’m ready to throw the dice for.

Take it steady,

The Accumulator

1. I have a lifetime tracker: 0.74 over base.[↩]
2. Sure I can rent a spare room, but you get my liquidity point.[↩]
3. My mortgage is interest only.[↩]

Good reads from around the Web.

Anyone who gets all their financial information from Monevator – hi mum! – won’t know that the US Federal Reserve decided not to dial back QE3 this week.

I didn’t write a post about it beforehand. I didn’t write a post about it afterwards. I haven’t even included articles about it in our Weekend Reading roundups for the past few months.

Now that might not sound to you like a shocking dereliction of duty. Who cares if some Central Banker buys $10 billion fewer bonds a month in a multi-trillion dollar economy?

To which I say:

1) Congratulations, you’ve just said something more sensible than 90% of financial pundits on the subject.

2) You obviously haven’t watched CNBC or Bloomberg since May.

Since late May, the financial media and markets have ceaselessly speculated about “the taper” – not the Barry Manilow-snouted beast of South America, but the extent to which the Fed’s quantitative easing would be scaled back, and how this would effect financial markets.

I can hardly exaggerate the amount of coverage it has got. I wouldn’t be surprised to learn that 50% of CNBC’s daytime output was devoted to taper-talk.

Admittedly that’s like castigating EastEnders for focussing on Albert Square, not Syria. CNBC is about entertainment, not what matters most in markets and investing.

But even so, it’s sidesplittingly hilarious to me that after all that speculation, Bernanke didn’t taper.

Nearly everyone was wrong. What a waste of time and breath!

For the professional pundit of course, no news is good news. They can just re-run all their taper talk for another three months. It sure beats truly educating people about investing, or even companies. ¹

But I wouldn’t look for a volte-face from me, nor any sudden explosion of taper speculation here on Monevator. Here’s why:

• Low US interest rates matter much more than Fed bond buying. The Fed funds rate is going to stay low for years, because it’s explicitly linked to an unemployment rate trigger that’s far, far away.

• Even the part of QE3 that does matter – mortgage-backed security buying, which is mildly helping the US housing market – isn’t as important as core rates.

• Market rates – such as the 10-year Treasury yield – had approached 3% just on speculation about tapering. The rise did what Bernanke wanted without him doing anything, in my opinion.

• But my opinion on this isn’t worth any more than all those talking heads on CNBC, so I won’t be sharing it here much.

• They nearly all got it wrong. So who exactly am I going to be quoting?

• Whatever we do or say, you and I aren’t likely to outthink the US bond markets, which is one of the most liquid markets in the world.

Finally:

• The 90% of financial bloggers and commentators who’ll tell you the US and UK bull markets are a fantasy built entirely on easy money from the Federal Reserve are wrong. They are guys with hammers looking for nails. Of course low rates have been crucial triage for the banks, and for steadying the underlying economy, but it’s not magic or trickery, it’s what always happens. It’s a price our future selves pay for less pain today. Read some market history. Pundits always say the same things. Somehow we push on, make more products, boost productivity, have kids who want houses…

Here end-eth the macro post of the month.

[continue reading…]

1. Slight exception made for the daytime Fast Money, which is by far the best of CNBC’s output, although it’s only for active traders.[↩]