Seeking Alpha

Closet Index Funds Get A Kicking

by: Henry Cobbe, CFA
Henry Cobbe, CFA
Portfolio strategy, ETF investing, research analyst

UK regulator forced a number of asset management firms to pay £34m compensation to customers for “closet indexing”.

Closet indexing means funds are presented as higher cost active, but actually just hug their benchmarks.

We estimate there is €0.4 to €1tr of assets in “closet index” funds in Europe, depending on what criteria are applied. Either way, fund houses have been warned.

“Mutton dressed as lamb” is a derogatory old saying of something or someone that’s dressed up to look better than it is. In olden days, some dodgy butchers would dress mutton up to look like lamb to get a higher price. I’ve got nothing against mutton. It offers good value for money and does a nutritious job. But I don’t want to be given one thing when sold another.

Some “active” funds that actually hug an index is another form of misrepresentation. And this month, the UK regulator got tough forcing a number of fund houses to pay £34m compensation to customers overcharged by closet index funds.

As this is the first closet indexing fine of its kind internationally, it’s worth taking a closer look.

What happened?

The furore is around “closet indexing” where mutual funds charge active fees to deliver an investment style that pretty much tracks the index which it aims to outperform. When marketed as active, this is misrepresentation. Furthermore, closet index funds offer poor value for money compared to genuine index-tracking fund or ETFs for the same given exposure.

What exactly is closet indexing?

“Closet indexing” is a term first coined – in public at least – by academics Cremers & Petajisto in 2009.

The study and metrics around “active share” and “closet indexing” caused a stir in the financial pages on both sides of the Atlantic as active managers started to watch the relentless rise of ETFs and other index-tracking products.

In 2016, ESMA – the pan-European financial services regulatory coordinator – undertook a study whose findings were published in 2016, outlining the potential scale of the problem in Europe.

In a Market Study published by the UK regulator in June 2017, the FCA put asset managers on notice that it would be investigating closet index funds as an area that offers poor value for money for customers and potential misrepresentation.

In March, the UK regulator struck after sampling funds from 19 UK asset management firms. Of the 84 suspected closet index funds reviewed, the FCA required changes to the descriptions of 60 funds to ensure they were not misleading. Furthermore, an undisclosed number of unnamed firms managing an undisclosed number of funds were required to compensate their customers £34m: not for providing index-like returns, but for saying one thing and doing another.

To be clear, the issue around closet index funds is not simply about fees. It’s as much about transparency and customer expectations.

How can you define “closet indexing”?

There has been some speculation as to what methodology the FCA used to deem funds a closet indexer.

In this respect, ESMA’s 2016 paper may be informative. Their study applied a screen to focus on funds with 1) AUM over EUR50m, 2) an inception date prior to January 2005, 3) Fees of 0.65% or more, and 4) were not marketed as index funds.

Having created this screen, ESMA ran three metrics to test for a fund’s proximity to an index: active share, tracking error and R-Squared.

The Closet Index Metrics in summary

  • Active share shows the percentage of the portfolio that does not coincide with index.
  • Tracking Error shows volatility of difference in return fund and index.
  • R-Squared represents the percentage of fund performance explained by index performance – a correlation measure.

On this basis, a fund with low active share, low tracking error and high R-Squared means it is very similar to index-tracking fund.

But what are the thresholds for each metric and how many funds are caught in the net?

A trillion-euro problem?

ESMA sets out three thresholds – each increasingly stringent – by which closet indexing could be defined. These are set out in the table below:

ESMA Closet Index Evaluation Thresholds


Tracking Error

% of European Active Funds

Est 2016 AUM Affected

Active Share <60%

TE <4%



Active Share <50%

TE <3%



Active Share <50%

TE <3% & R2 >95%



Source: ESMA, Elston

Based on Morningstar data we estimate the European funds industry to be approximately €8tr in 2016, implying on our estimates that €1.2tr could be defined (at its loosest definition) as closet indexing, with €400bn (at its tightest definition) coming under particular scrutiny.

Where next for fund houses?

Fund houses in the UK and Europe have some thinking to do. Are they offering building block components, or managing solutions? Our view remains that those offering solutions will prosper, whilst those offering building blocks risk commoditisation.

Price pressure from index funds and ETFs has been present for a while, but so far traditional brands and distribution networks have proven resilient. But with the regulator now joining in to target closet indexers, the “big switch” for core exposures from actively managed funds to index-tracking funds is likely to accelerate, in our view.

Embracing change

Rather than embracing change, European asset managers that don’t currently offer ETFs have so far been hesitant to launch. They should get over it. Fund houses have embraced different fund wrappers which have over time: investment trusts (one of the earliest just celebrated its 150th anniversary), unit trusts, OEICs, SICAVs, ICVCs to name a few. ETFs are just a not-so-new tradable way of delivering a basket of securities to the investor. Technology changes. Purpose does not.

So European asset managers should launch, not fear, ETFs. Or watch their American cousins eat an ever cheaper lunch.

A winning formula

Tomorrow’s winners in the European asset management space, in our view, are those firms that are:

  • close to asset owners;
  • can offer solutions as well as components; and
  • are part of the low-cost revolution, not victims of it.

Fund houses that meet all three of these tests are in good shape. There are some big British behemoths that don’t yet meet those tests. Unless they act, they risk getting left behind.

Indexing and proud

Index investing is transforming the UK retail investment landscape. It is creating a Moore’s Law for fund manufacturing. It’s time to get involved.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Additional disclosure: This article has been written for a UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) or “LON:” (London Stock Exchange). For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates. For information and disclaimers, please see Photo credit: as per specified source; Chart credit: as per specified source; Table credit: as per specified source. All product names, logos, and brands are property of their respective owners. All company, product and service names used in this website are for identification purposes only. Use of these names, logos, and brands does not imply endorsement.