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By Detlef Glow Click to enlarge Closet trackers or closet indexing funds are a hot topic in Europe. Market observers are questioning the added value delivered by active managers who follow their index very closely, and regulators are looking into the business models of those asset managers. A number of funds under review with regard to closet indexing charge active management fees. Even though this seems to be a worthwhile topic for discussion, the critical discussion may go too far, as Jake Moeller-Thomson Reuters Lipper’s Head of U.K. and Ireland Research-described in his article ” Closet Trackers – Storm in a Teacup ” published earlier this year. From my point of view the discussion of closet indexing misses two very important reasons that may lead fund managers to a closed indexing approach: the size of the fund and the risk management process employed by the asset manager. Fund Size One point often neglected when discussing closet indexing is that funds may need to move in the direction of the index when they grow in size. The reason for this is quite simple: The larger a fund gets, the higher the order volume in a given security becomes. Since the securities in the index normally offer the best liquidity, the fund manager may need to buy these securities to fulfill the liquidity needs of the fund and its investors. Other than a fund promoter limiting access to a given fund by subscription rules, there are two common strategies a fund manager, driven by fund flows, can use to avoid becoming a closet tracker. Neither strategy may favor the fund promoter, since they limit fund sales, but both strategies seem appropriate to protect a fund from becoming too big. The first strategy is the so-called soft closing of a fund, meaning that only investors who already hold shares of the fund can buy additional shares. This technique is very commonly used by fund promoters, but it doesn’t help when the existing investors continue to buy more and more shares of the fund. In this case it is time for a hard closing, meaning no one can buy additional shares of the fund. Since investors can still sell shares of the fund, there is a chance the fund will reopen. In some cases the fund promoter maintains a waiting list, and all redeemed shares are sold directly to an investor from this list. As with a closed-end fund, it is always possible to list an open-end mutual fund on an exchange so that the redemptions can be directed to investors looking for shares of the fund. Risk Management Process A second reason for being a closet tracker might be the risk management process of the asset manager. Risk in this case is defined as additional risk to the benchmark (index) of the fund and not the risk of losing money. The holdings of the fund are monitored against the constituents of the benchmark, and the portfolio manager has only limited room to move away from the benchmark in terms of sector, country, and regional weightings. In some cases fund managers also are restricted at the securities level, so that a negative view on a single security means this security has a 10% lower weighting in the fund than in the benchmark. For example, the weighting for the security in the index is 3% while it is 2.7% in the fund. Such internal rules and guidelines lead automatically to closet indexing, and one can’t blame the fund manager for this. Even though the risk management process is a very important part of the due-diligence process of fund selectors, selectors need to think very carefully about the impact on the fund manager coming from the overall portfolio and risk management process. From my point of view every fund that charges a fee for active management should not stick too closely to its index, since this limits the ability to deliver an above-benchmark return to the investors. But on the other hand, it is the duty of the fund selector to identify those limits and to make a decision about whether the fund is the right vehicle for the investor. For retail investors it is even harder to evaluate the performance potential of a fund, since retail investors often have the chance to select a fund only based on its past performance and the official documents such as the fund prospectus and the key investor information document (KIID). This means a retail investor has to monitor the performance of the funds in his portfolio even more closely, since that might be his only chance to identify closet trackers and to make a decision as to whether to continue holding the fund. I think litigation, especially when institutional investors are involved, such as that being undertaken in the Nordic countries, is the wrong tack, and it will/should not be successful. The investor bought the fund for a reason and needs to check it frequently to see that the vehicle is still the right product for reaching a predefined goal. The views expressed are the views of the author, not necessarily those of Thomson Reuters Lipper.