Underestimating closet tracker funds problem

Closet index funds may be a much bigger problem than European regulators have suggested.

In February, a European Securities and Markets Authority (ESMA) report cautioned that between 5 and 15 per cent of supposedly actively managed European funds may be closet trackers. Both figures seem extremely low; last year, UK wealth manager SCM Private cautioned that more than a third of British funds could be termed closet trackers, while a separate study estimated about a quarter of money invested in Irish-sold funds was sitting in closet trackers.

Last week, SCM tested out the methodology used by ESMA, and found many actual index funds were not identified as trackers.

Why? SCM notes that funds report their pricing many hours before indices close for trading; as a result, even index funds’ performance will appear artificially different to their benchmark.

ESMA's response to what appears to be a truly daft cock-up was casual, to say the least, telling the Financial Times that its report merely aimed to determine if there might be any problem of closet indexing; national regulators could undertake more detailed investigations.

In Ireland, the Central Bank is investigating the issue, as are regulators in the UK, Denmark, Germany, Luxembourg, and Sweden. Don’t be surprised if the real figures are much graver than the seemingly shoddy estimates churned out by ESMA.

Goldman warns on valuations

Markets have been a little nervy lately, and things might be about to get nervier in the coming months, Goldman Sachs warned last week.

Goldman cut its rating to neutral on stocks, saying a variety of risks could catalyse a 5-10 per cent drawdown in the coming months.

One such risk is valuation – the median US stock is more expensive than it has been on 99 per cent of occasions over the last 40 years, says Goldman. Goldman is not outright bearish; in fact, it says stocks will end the year slightly higher than they are today and recommends buying back into stocks after they dip.

However, is there any evidence that valuation can help time the market in this manner?

In February, quantitative investor and Alpha Architect blogger Dr Wesley Gray back-tested various trading systems whereby you exit the market when it is trading at the 99th percentile and buy back in when stocks get cheaper.

The data showed that “Goldman’s ‘valuation-timing” concept doesn’t have legs”, he said; there is “nothing magical about the 99th percentile”.

It’s wise to be similarly sceptical about the five “conviction themes” outlined by Goldman last week. In January, Goldman outlined six top trades for 2016; within six weeks, five of them had been abandoned.

Betting against Brexit

A British vote to remain in the EU next month might catalyse decent gains for UK equities, judging by Merrill Lynch’s latest monthly fund manager survey.

“If you go down to the woods today, it will be full of bears,” said Merrill last week, noting how investors are prepared for a “summer of shocks”.

Cash levels are extremely high and very few fund managers are taking above-average risk, with Brexit deemed to be the biggest risk facing global markets.

Most – 71 per cent – see Brexit as either “unlikely” or “not at all likely”, but they’re not taking any chances, with allocations to UK equities hitting their lowest level since November 2008.

Brexit is not the sole source of revulsion towards the commodities-heavy UK market, but the sudden deterioration in fund manager sentiment indicates it is a big factor.

Brexit remains unlikely, but the mere prospect is nevertheless dampening sentiment, making the FTSE appear like an attractive bet for contrarian investors.

Impatient millennials

Wealthy millennials appear to be an impatient bunch, judging by a global survey carried out by US fund giant Legg Mason.

The survey found that just a fifth of affluent millennials – investors aged 18 to 39 – were willing to hold on to an underperforming investment for more than a year.

Younger investors also have a “short view of long term”, said Legg Mason; 35 per cent defined long term as two years or less, with another 26 per cent defining it as a two-five-year period.

British millennials were particularly unforgiving, just 14 per cent saying they would hold on to an underperforming fund for more than a year.

Their older counterparts were not much better; 62 per cent of over-40s said they would dump a fund that underperformed over a 12-month period.

These are remarkable figures – the very best funds routinely suffer long periods of underperformance, and countless studies confirm that chasing “hot” funds and sectors is a lousy idea.

Judging by the survey, the unfortunate phenomenon of performance-chasing is not going to go away any time soon.