Supervisor Investigates Closet Indexing

The European Securities and Markets Authority (ESMA) has published a statement providing details of its work on closet index tracking funds.

Closet indexing, also known as ‘index hugging’, refers to the practice of fund managers claiming to manage portfolios actively when in reality the fund tracks close to a benchmark (passive management). ESMA is concerned the practice may harm investors as they are not receiving the service or risk/return profile they expect based on the fund’s disclosure documents whilst usually paying significantly higher fees compared to those typically charged for passive management.

“Closet indexing is an issue which has attracted the attention of investor protection groups and investors alike throughout the European Union and ESMA has played a key role in an EU-wide inquiry to get to the heart of the matter.” Said ESMA Chairman Steven Maijoor in a statement.

ESMA conducted research on a sample of 2,600 funds for the period 2012-2014 to determine whether it could find any indication of closet indexing at an EU-wide level. It reports that quantitative metrics, such as the percentage of a UCITS’ portfolio that does not coincide with the underlying equity benchmark, indicated between 5% and 15% of UCITS equity funds could potentially be closest indexers.  The results of the study underline the need for additional supervisory work in this area.

Fund Disclosures

The supervisor also reviewed the investor disclosure documents of the funds concerned in order to see how they described their management strategy, and found they tended to confirm the quantitative analysis results. ESMA considers it important that fund managers take their commitments to disclosure documents seriously. Fund Managers should expect supervisory consequences where evidence for incorrect disclosures is proven.

“Investor protection is core to our mission and the preliminary findings raise questions that merit closer analysis. Fund managers must provide investors with information that is fair, clear and not misleading. In partnership with national regulators we are taking a closer look into this issue.” Maijoor commented.

The current rules on fund disclosures require that fund managers provide investors with information that is fair, clear and not misleading. ESMA recommends that UCITS management companies carefully consider whether the information they provide to investors is an accurate interpretation of the performance objectives of the fund and the amount of risk taken to generate that return is in line with their obligations under the KIID Regulation.

In order to put investors (both retail and professional) in a position to make an informed investment decision, ESMA suggests that they should make use of all the documentation available to them when selecting a product. When considering an investment in a UCITS equity fund, regardless of the style of fund management, investors may also wish to compare the key elements of the product to those of a number of other products (including some that adopt a different management style). Although past performance is not a reliable guide to future returns, there may also be value in assessing whether a fund has been able to achieve the objectives referred to in the fund documentation.

Next Steps

ESMA and national competent authorities have committed to additional work on potential closet indexing. This will include an active role for ESMA in the coordination of further analysis carried out at the national level, while fuller investigations on a fund-by-fund basis will necessarily fall in the remit of national competent authorities, as part of their regular supervisory work. Together with national competent authorities, ESMA will also assess the need for further steps to ensure that all market participants comply with disclosure obligations to the full extent. Where ESMA has identified potential shortcomings in the UCITS framework that could create a potential for closet indexing (e.g. on disclosure obligations), it will analyse the need for further clarification, with a view to creating a level playing field for all stakeholders across the European Union.

The ESMA Statement is available here.

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