12 December 2014

CEPS: Why the regulatory witch-hunt for ‘closet trackers’ is a dead-end

ESMA announced its intention to take a closer look at so-called ‘closet trackers’, with a view to identify whether there is a potential need for a coordinated pan-European policy response to these particular funds, which are supposedly actively managed but in reality closely track their benchmarks.

Jean-Pierre Casey suggests that more work needs to be done to demonstrate that a market failure exists. He also cautions on some of the difficulties associated with a potential regulatory intervention. In his view, the perceived problem is best tackled through transparency and competition.  Regulators ought not to fall into the clever lobbying traps set by the passive industry to increase their market share – in what is already rapidly becoming an oligopoly, or even a duopoly. In order to remain impartial, it would be dishonest to suggest that passive investing is anything other than an absolutely critical part of the financial ecosystem. The passive investing industry is unambiguously one of the great and positive financial innovations of the past half century. It responds cheaply and effectively to the demands of a huge range of institutional and private investors.

But active investing is also a critical part of the financial ecosystem, including some investment strategies, which may come under the fold of still-loose definitions of closet tracking. As just one example, closet trackers might contribute to financial stability, as ETFs are more beholden to short-term investor flows than actively managed funds. Rapid tactical shifts in and out of ETFs to benefit from market momentum, temporary tactical tilts in asset allocation, or for risk management purposes, can occasionally lead to more violent market gyrations – probably in large part because they are cheaper. In a bid to separate the wheat from the chaff, regulators and consumer rights advocates might inadvertently damage the fragile balance of the financial ecosystem. Greater financial market volatility and instability would be a high price to pay to shave a few tens of basis points off the annual cost of certain types of managed investment.

From a consumer-protection perspective, investment benchmarks are useful proxies of risk. Indeed, they are the pillars of consumer protection regimes such as MiFID and UCITS. The very purpose of an ex-ante regulatory requirement for a fund/investment manager to identify the benchmark to which he/she is managing the portfolio is to allow the investor to make an informed decision on the potential riskreturn characteristics of the investment. To the extent that closet trackers are seemingly being encouraged to deviate more from their benchmarks, the usefulness of the benchmark as a gauge of risk becomes less relevant or meaningful – with potentially detrimental results for consumers. For example, the case of a country index, which is populated with defensive stocks, such as utilities. Depending on market conditions, an active manager might take a conscious bet, with a bearish view, to hug the defensive benchmark rather than taking big bets on cyclical stocks within or outside the index. Such benchmark hugging, in particular cases, is anything but detrimental to investors. On the contrary, the ability of an active manager to hug a benchmark as a defensive strategy, whether occasionally or even over prolonged periods of time, might help preserve investors’ capital.

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