Pull closet indexing out of the closet In the UK, people are trying to pull closet indexing out of the closet. It is a fight that could have global implications. This is one issue on which there is no need to sit on the fence. The debate between active managers, who try to beat their benchmark, and passive managers, who merely track it, will go on and on. But everyone can agree that there is no case for closet indexing - the practice of running an "active" fund, charging active management fees but, in practice, offering an investment that merely hugs the index. John Authers This is, in effect, a tax on millions of investors, for no economic benefit and helps pump up asset bubbles. It impedes capitalism and the efficient allocation of capital. Closet indexing has been a problem for many years but it has moved to the top of the UK agenda thanks to a report published last month by SCM Private, a London-based investment adviser, which described closet indexation as "a UK epidemic." After analysing £120bn in UK funds, it alleged that investors could have saved £1.86bn in fees if they had switched from underperforming UK equity funds to alternative cheaper index funds. SCM Private emotively accused the UK fund industry of "systematic abuse of the public" and alleged that it had failed to behave with integrity. This is strong language, so let us look at the charges in detail. Closet indexing has been well explored in academia. It is measured by "active share," a concept invented by the Yale academics Antti Petajisto and Martijn Cremers. For US funds benchmarked to the S&P 500, it measures the fraction of a fund's holdings that differ from the S&P. For example, if a fund's holdings are identical to the index, except that it holds no shares in Apple (worth 5 per cent of the index) and has invested that money elsewhere, it will have an active share of 5 per cent. A passive index tracker has no active share. A fund that invests only in obscure stocks not in the benchmark has an active share of 100 per cent. Once active share drops below 60 per cent, the academics said, a fund is a possible "closet indexer." SCM Private found that only 24 per cent of 127 UK funds benchmarked to the FTSE-All Share index had an active share above 70 per cent. This compares with 65 per cent of a sample of US funds that had an active share this high. Overall, the UK funds had an active share of 60 per cent, compared with 75 per cent in the US. The chances are tiny that a few tweaks to the index would do well enough to overcome the extra fees that active managers charge, which are on average three times the fees charged by trackers. And indeed 88 per cent of funds with an active share under 50 per cent did not match their index. Closet indexing has been a problem for many years, but it has moved to the top of the UK agenda thanks to a report by SCM Private, which described closet indexation as a UK epidemic Why does this happen? The problem derives from the incentives for fund managers who are paid not to beat the market but to accumulate assets. This is because they charge a percentage fee on assets under management and are judged by comparison to their benchmark index and to their peers. To hold on to assets, therefore, it is vital not to underperform their peers. Make a big contrarian bet and you may be separated from the herd. So everyone herds into the same stocks. As passive investing through index trackers has taken hold, active managers have grown more conscious of their benchmark index. This is clear from the language they use. Two decades ago, a portfolio manager would say he "owned" a stock. Now he is more likely to say he is "overweight" it, always implicitly comparing with the index. This phenomenon helps create investment bubbles, as overvaluations naturally occur when everyone invests in the same thing. It also creates opportunities for those who have the courage to search for them. SCM Private found that 72 per cent of the UK funds with a high active share succeeded in beating their index. This is in line with international research. The Cremers and Petajisto research found that in the US, funds with the highest active share beat the index by more than 1 per cent per year, even after taking their fees into account. The UK is not alone. Research led by Mr Cremers looked at 21,684 funds in 30 countries, managing some $10tn as of December 2007. Closet indexing was dominant in some countries, accounting for 40 per cent of equity funds in Canada, and 81 per cent in Poland. It also found that countries with the most explicit indexing were also likely to have less closet indexing, while active funds there would charge lower fees. Passive trackers provided stiff discipline for the rest of the sector. It also found that most active funds fail to beat their benchmark - but that the more genuinely "active" a fund, the more likely it was to outperform. Fixing the problem needs a radical overhaul of the way fund managers are paid. For now, funds must be forced to publish their active share. Before being flushed down the toilet, closet indexing must be pulled out of the closet.