Defining ‘closet tracking’ is a hotbed of regulatory arbitrage

Jean-Pierre Casey, 10* December 2014

The active versus passive investment debate has taken a new turn. Esma, the European watchdog of securities markets, is to take a closer look at so-called “closet trackers”, with a view to identifying whether a co-ordinated pan-European policy response is needed.
The fact that many active fund managers are not able to beat market indices consistently on a risk-adjusted basis and/or net of fees — and yet still charge management fees that can be multiples of passive strategies — suggests that passive investments such as exchange
traded funds ought to occupy a greater share of investment portfolios.
Over time, costs can erode the net returns to investors significantly. Thus focusing on the relative costs of different investment products is not misguided, particularly against the backdrop of an ageing population and an accelerating transition from defined benefit to defined contribution pension schemes, which will increase the importance of private asset management in marshalling savings into long-term investments.

Yet the path to a balanced regulatory intervention is fraught with dangers, and could potentially do more harm than good, including from a consumer’s perspective. Two of these difficulties are particularly salient. First, defining what constitutes a closet tracker may appear easy in theory, but becomes far more difficult in practice. Is a closet tracker one that mimics a benchmark index “too much” in terms of its composition and weightings; replicates the performance of an index “too closely” (even though their compositions may differ) or one whose tracking error vis-à-vis the index is deemed “too little”; exhibits a turnover deemed “too low”; displays high correlations to market indices? Is it all, or some, of the above?

Clearly a credible definition of closet tracking would necessitate setting quantitative thresholds around turnover ratios, portfolio composition, tracking error, correlations and other relevant metrics. Arriving at those thresholds in a non-arbitrary fashion would be exceptionally difficult.
On the other hand, rules that do not quantitatively define closet tracking would either have no bite, or give regulators far too much discretion. The latter would increase regulatory uncertainty, stifle product development and create a hotbed of regulatory arbitrage.

The second difficulty concerns how regulators would establish what constitutes a “fair price” with respect to passive investing. That is, in a way, the crux of the problem. If it were not for the higher active management fees closet trackers charge, nobody would be fussing over them. As an opinion on what the price of a passive investment ought to be, the witch hunt for closet trackers amounts to nothing other than price regulation and implies a ceiling on prices investors should pay for passive investment strategies.

That formal regulatory intervention is even being considered in relation to the fees charged by providers is worrying. This has nothing to do with regulating for transparency, consistency or comparability of prices. The best regulatory tools to tackle this perceived problem are transparency and competition. These tools are already available to regulators through various disclosure, suitability and conflict of interest management measures embedded in EU legislation, particularly the Mifid and Ucits directives, which form the backbone of investor protection in relation to the European asset management industry.

It is not immediately apparent that a market failure exists in relation to closet trackers, nor that regulatory interventions of the kind suggested would lead to improved outcomes for consumers. Sometimes the best course of policy action is inaction. May this lesson not
be lost during the exercise regulators are currently undertaking on closet trackers.

*Article published in FT on 7th December 2014; an enhanced article is available at CEPS.


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