Index Hugging +

Amongst the list of things wrong with a lot of the active fund management industry (underperformance, high fees, opaqueness etc.), there's something all investors (and advisers) can do to ensure they are making better decisions: not buying closet trackers.

Closet index tracking, or index hugging, refers to funds that are marketed as being actively managed (thereby charging a higher management fee), but are in fact just tracking an index, or deviating only marginally from an index.

In other words, you're paying an active manager to make active decisions. But, it turns out, they are lily-livered and scared of making a bad call so they stick with the flock.

It's like your partner telling you they'll make you a nice dinner only to pop to Tesco or Family Mart to pick up a ready made meal. If you don't feel cheated, you can simply skip to the next section.

In the past, some big names have been exposed of potentially selling funds that are closet trackers, including Schroders, Fidelity and JP Morgan. Generally, you can expect lower net returns and higher fees from closet trackers than from a genuinely actively managed fund.

So what can you do? If you're deciding between an active mutual fund or a passive index fund equivalent, take a look (if you can find it) at a number called active share, which is expressed as a percentage on any active fund. It tracks the disparity between a fund manager's holdings and that of its benchmark index. It's simple, easy to calculate and doesn't require any special formulas or assumptions.

A low active share indicates that a manager is closely replicating the index and is verging on a passive strategy. A high active share indicates that a fund's holdings diverge from the target index and there is genuine active management. You generally want an active share of more than 70%, otherwise you're paying someone to faff around with no conviction.

Some fund managers will of course hit back and argue that active share provides no indication of a manager’s ability to pick good stocks. Whilst there is some truth to this, I don't think a lot of them really have a leg to stand on when they present their long term performance relative to the benchmark and then try to justify their fees.

That being said, the context of the market the fund invests in does in a sense matter from an active share point of view. In a broadly diversified market like the U.S., an active fund manager can deviate from the index much more easily, without excessively diverging in terms of style or market cap. This is unlike a narrower market such as Italian or Singaporean equities, that have highly concentrated benchmarks and only a short list of constituents.

If you care to know more about the context of how active share differs depending on the market, I'd suggest reading this analysis about active share from a UK perspective.

For most people though, more analysis bears little significance when it would just be easier to understand the simple concept and not fall into the trap.

There are other arguments as to why a focus on active share is misplaced, some of which are justified. But I'll listen to those when there is statistical evidence that the majority of active managers outperform their benchmarks over a sustained period of time. Which probably won't happen anytime soon.

+👂 Masters in Business: James Anderson on Why Fund Management Is 'Broken'. Anderson is a legendary investor and partner at Baillie Gifford, the Scottish investing giant that manages $470 billion. He declares the fund management business to be ‘irretrievably broken’, observing “fund managers are addicted to the near-pornographic allure of earnings reports and macroeconomic headlines.” They are overly focused on short-term returns while failing to recognise that great companies take years to develop. [Listen: Apple | Spotify | Google | Bloomberg]

📖 Read

The Rise and Fall of Chimerica. This discursive essay was too good not to read twice. Jacob Dreyer, a writer based in Shanghai, argues that for China, America has primarily been a mere "idea" that subsumes a diversity of experiences, almost a utopian model to emulate. However, Dreyer delves into the Chinese intellectual universe and reveals how China's rise has coincided with a desire for it to realise its own true identity and emerge from its American shadow.

He questions whether the Chinese population is experiencing a fake reality, or an advanced society built on "Chinese essence", and how western political and philosophical ideas are being reshaped in the country as China offers both material and spiritual sustenance to its population.

"Despite the oppressive restrictions for most people, China this summer simmered with hopes for the future, a sense that certain things needed to change. But unlike previous times like this, America didn’t seem like the answer to any of the questions. Increasingly, China is not following in the footsteps of others, but charting its own path." I agree with this, but I know there are many who will not. Including those I speak to who want nothing more than the freedom to leave. But I guess they represent just a fraction of the national mindset, the majority of which approve of the actions the country has taken and the path on which it is going. [Noema]