The key European regulation organisation, ESMA, has recently been looking into the issue of closet trackers or index huggers (I prefer the term quasi-tracker, or quackers for short). The implication is that some asset managers are charging active fees for what are in essence tracker funds.

Our focus is on funds that meet investor outcomes, funds that assess risk versus a volatile benchmark don’t really meet these needs. As a result, Square Mile would rarely look at a quacker type fund, much less recommend one. However, I would not be surprised if some funds run by certain groups end up been accused of being closet trackers. Frankly, we haven’t investigated the issue and we focus our efforts on identifying good funds, not bad ones.

There are two main ways to assess a fund’s ‘activeness’. The traditional approach is ‘tracking error’, which is the volatility of a fund’s returns relative to the benchmark. A more recent development has been to delve into portfolio holdings and compare the position sizes to those of the benchmark. This is called the ‘active share’. ESMA has identified a number of funds in Europe being run with a low active risk and a low tracking error. Could these funds be run more in the interests of the asset manager business rather than the underlying investor?

Fund buyers can reasonably easily calculate tracking errors, though active share is not so easy to determine. If the best disinfectant is sunlight then it might be helpful if more fund groups provided active share information as a matter of course for their mainstream equity funds.

That said, some funds are run with restricted tracking errors and active shares because this is precisely what their mandate dictates. When I started my financial career in the 1990s, it was not unusual within the institutional marketplace for mandates to be heavily constrained. Who remembers the Unilever Superannuation Fund case against Mercury Asset Management in 2001?

Funds operating with a tight tracking error objective of 2% and associated fees of 1%, necessitate a manager to generate outperformance with an information ratio of 0.5 merely to cover the fees. Long term information ratios around this level are associated with managers exhibiting real skill. If you’ve taken the trouble to identify good managers, why would you ever want to give them a mandate that restricts their skills so heavily? This is like buying a Ferrari with a speed limiter set at 20 mph – it’s just plain quackers.