How a different disclosure method could flush out closet indexers

How a different disclosure method could flush out closet indexers

How a different disclosure method could flush out closet indexers

Faced with pressure to lower their fees, many active managers are faced with two choices: deliver juicy returns that would convince investors they’re earning their keep, or reduce their fees. With the latter option, managers would then have to choose between getting less profit and finding costs to cut.

Of course, some managers may actually be cutting corners through closet indexing, charging active-level fees even though they’re simply hugging an index. The issue has gotten some attention in Canada — and it’s getting even more across the pond.

“In the UK, this phenomenon is monitored by the Financial Conduct Authority, which has introduced rules on how funds benchmark themselves,” noted Alex Edmans, professor of finance at London Business School and Gresham College, and Tom Gosling, executive fellow of the London Business School, in a piece for the Financial Times.

As in Canada, the issue of closet indexing is important because it erodes the value that investors get. But according to Edmans and Gosling, it creates an additional problem by hindering effective stewardship. By holding companies to account for long-term value and insulating them from short-term pressure, investor stewards can help improve saver returns and long-term company performance improve.

According to the piece, academic research demonstrates that active and index strategies both play a role in stewardship. Index funds can be effective at generalized stewardship, which entails implementing best practices — such as eliminating takeover defences and increasing director independence — that can be applied across all companies. Active investors, meanwhile, can take on more in-depth stewardship issues like strategy, capital allocation, and intangible investments.

Edmans and Gosling said that specialized stewardship can only be done by investors with a thorough understanding of a company. They added that a large stake is necessary to convince an investor that the costs of monitoring and engagement will not go to waste. That means active funds must be truly active, with each name they own being a “conviction holding” that they are committed to steward.

One way to encourage the large stakes needed for effective research is to consider active share, which assesses the degree to which a fund deviates from the benchmark. Based on academic research, active share also positively predicts a fund’s performance.

The two authors proposed that funds be required to disclose their fees adjusted for their active share: the more active share a fund has, the more it can justify itself as an active strategy, and the higher the fee it’s able to charge.

With that type of disclosure, investors would be able to see how much they’re actually shelling out for active management. At the same time, it would also decrease the temptation for active funds to cut costs and fees by secretly hewing closer to an index.

“Enhancing fee disclosure will achieve competitive differentiation in an industry that is increasingly commoditized,” Edmans and Gosling said. “It will also highlight the active managers who are committed to active ownership and dedicated stewardship.”

 

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