Skip to main content
Blog Post

Closet index funds – Where does the buck stop?

Financial, Executive and Professional Risks (FINEX)|Securities
N/A

By Dominic Pilgrim | October 1, 2019

Regulators are cracking down on funds that purport to be actively managed but simply shadow an index.

Are you a “closet index hugger”? The terms ”closet indexing” and “hugging the index” are used to describe fund managers who claim to actively manage portfolios when in reality their funds simply shadow an index. This practice has caught the eye of regulators. Investors are charged higher fees for actively managed funds, because, well, they are supposed to be actively managed, and if a fund simply shadows an index, it will generate lower returns than the index fund due to its higher fees.

From 2012 to 2014, the European Securities and Market Authority conducted research on a sample of 2,600 funds to determine whether it could find any indication of closet indexing at an EU-wide level. More recently, The Central Bank of Ireland identified 182 UCITS funds alleged to be involved in closet indexing. The regulator forced boards to take action on the transparency of the funds’ investment strategies in prospectuses and key investor information documents (KIIDs).

The primary concern for the regulators is the level of disclosure being provided to investors and whether those investors are actually given sufficient and accurate information about the fund’s strategy. Despite increased pressure on transparency and good governance over the past couple of years, we are still witnessing areas of mis-selling, misrepresentation and breaches of trust, which can damage the reputations of companies of all sizes.

With an estimated $140 billion of investor money sitting in potential closet trackers, regulators are likely to continue  scrutinising the asset management industry closely.

What can funds and management do to rectify these issues?

Amid regulators’ increasing pressure, boards of directors need to ensure that fund documentation is updated to clearly, fairly and unambiguously reflect the fund’s strategy. Regulators have given sound advice to funds to correct their documentation by setting out improvements and mitigations and arranging deadlines to adhere to these targets.

If the documentation has not been updated for some time, efforts should be made to revise the KIID or prospectus to include the target outperformance of the fund against the reference benchmark and details of other risk constraints that may limit the performance of the fund versus a benchmark, as contained in the marketing material. The board of directors must then disclose those revisions to investors, despite the potential impact of creating unforeseen challenges from investors.

Who is deemed responsible for the accuracy and transparency disclosed within the KIID or prospectus?

It could be argued that the buck stops with the fund directors who ultimately sign off on the final KIID or prospectus. However, responsibility can also fall to the fund manager who promotes and markets the offering to potential investors. A number of insurance policies cover both the fund manager and the fund. It is therefore worth understanding how the insurance would respond to claims involving both the fund manager and the fund. For example, should the directors of the fund share the limit of liability with the directors of the fund manager and, if so, are the limits sufficient?

How will your insurance policy respond?

It is vital to ensure that the protection you have in place is fit for purpose. Remember, the devil is in the details and that hindsight is the judge when it comes to an insurance contract! It is therefore essential for fund directors to question the adequacy of their insurance protection should a regulator tap on their front door asking for an interview and/or request for information as to whether investors have been treated fairly.

Such events will incur costs as well as increase the potential risk of investors alleging misrepresentation or mis-selling via the KIID or prospectus. Failure of the insurance policy to respond could potentially impact the personal assets of the individuals concerned as well as the reputation and resulting balance sheet of the fund manager.

Demands for transparency and good governance are unlikely to decline. Managers – and boards of directors – should continue to scrutinize their funds’ prospectuses or KIIDs before regulators do, and ensure they have right insurance in place to protect them if things go sideways.

Author

Dominic Pilgrim
Senior Associate – Financial Institutions, FINEX Global

Part of the global financial institutions service team, Dominic provides insurance solutions and client service to an array of financial institution clients across the world.


Contact Us