What European -- and Canadian -- fund investors can learn from the United States

The curious case of closet indexing.

John Rekenthaler 10 December, 2014 | 6:00PM

Last month, news broke that the European Securities and Markets Authority was considering taking action against so-called "closet index" funds -- mutual funds that purport to be actively managed, but which in practice hold portfolios that are very similar to that of an index. ESMA is worried that such funds mislead shareholders by promising one thing and delivering another.

Or, perhaps ESMA is feigning concern, as a closer reading of the reports reveals that the fuss so far has come from other parties, with ESMA being pressured to take action. It may well be that ESMA is murmuring sympathy but has no intent of following through.

I do hope that it is the latter. Sanction funds for conducting risk management? Come on now. The only investment decisions that should concern regulators are those that pose unusual dangers -- which is clearly not the case with closet index funds, which err on the side of excess safety.

That said, ESMA's suspicions are correct: Most closet index funds are mediocre. On average, they make roughly the same returns before fees as index funds but charge higher fees. Voila! They typically have a lower net return. The concept is simple, and the math is even easier. This occurs in Europe just as in Canada and the United States.

This leads to the central question: If European closet index funds lag European index funds, then why are they a threat? After all, in the U.S., closet index funds require no restraining. Vanguard eats their breakfast, lunch, and dinner. Then it steals their midnight snack. Each week, Vanguard inhales more new assets than every closet index fund combined does for an entire year. If anything, American closet index funds need regulatory intrusion to survive.

Yet, in contrast, Europeans fail to understand the obvious.

The reason why owes not to the higher collective IQ of Americans -- a thesis that can easily be disproved by surfing U.S. cable television -- but rather to the structure of the European fund marketplace. Although things are changing, European funds are still primarily sold rather than bought, a bromide meaning that advisors generally operate in a sales-driven environment and that prospective investors lack the knowledge to question advisors' recommendations. Under such conditions, index funds can quietly succeed for decades without gathering much attention or many assets. The system is not efficient. The situation is very similar in Canada.

The U.S. was like that, back in the day. The large brokerage firms filled the role now played by large banks in Canada and Europe -- the organizations that prided themselves on distribution muscle, that measured success by hitting sales targets rather than customer-satisfaction numbers, and that steered clients to home-grown funds. There weren't many independent advisors to question the conventional wisdom and suggest a different path, nor did investors have strong beliefs of their own. At that time, closet index funds thrived in the States, too.

No more. The drumbeat from the press and independent advisors, increasingly echoed these days in other channels, is for indexing, indexing, indexing (and sometimes, I have argued, the case is made more strenuously than indexing deserves). Nobody can argue now that the strategy operates in the shadows.

The change did not occur because of regulation. It came from experience, from discussion and from the availability of alternative distribution channels, which spurred innovation and competitive pressure on the wirehouse brokers. It arose, in short, from collective insight.

The necessary conditions to defeat closet index funds:

  • True index funds are available. There's no threat to closet index funds without the existence of true, low-cost index funds. Not every European country offers a broad menu of index mutual funds, but all countries have access to exchange-traded funds. Thus, Europe meets this condition. Ditto for Canada.

  • Performance figures are widely disseminated. Europe and Canada also meet this condition. Fund returns are readily available.

  • Financial advisors embrace indexing. Even in the U.S., the home of direct investing, indexing did not become fully mainstream until financial advisors joined the party. In Canada and Europe, where direct investing is uncommon, advisors are even more critical. So far, for various reasons, advisors in Canada and Europe have shown little appetite for indexing; thus, the two regions do not meet this final condition.

In short, the problem in Europe, as it is in Canada, is not inadequate mutual funds but rather insufficient competition among financial advisors. There are not enough people offering different investment visions -- as U.S. advisors did by switching their compensation models so that they could bring to their clients low-fee funds offered by the likes of DFA and Vanguard, as well as institutional shares. There are also not enough investors comparing their results with those of their friends, noticing discrepancies, and asking hard questions. The status quo must be challenged.

The tide is turning in Canada with ongoing regulatory reforms, and Europe will eventually sort itself out as well. In the meantime, ESMA should focus its efforts not on dictating investment policy but rather on doing what it can to encourage competition among financial-advisory channels. Public relations would also help, as media coverage plays a key role in improving investor knowledge. The end goal is a fund marketplace that punishes mediocrity far more ruthlessly than does a regulatory slap.

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John Rekenthaler

John Rekenthaler  John Rekenthaler is Vice President of Research for Morningstar.