Index hugging: is this the next line of investor claims?
This article explains why, in our view, this is an issue that UK based asset managers may want to start looking at more closely.
Closet index tracking, also known as index hugging, refers to funds that are marketed as being actively managed (thereby charging a higher management fee), but in fact deviate only marginally from a benchmark index and therefore require, in practice, limited management.
Over the past couple of years, the issue of index hugging has grown in prominence in Europe, both as a result of litigation commenced in Scandinavia, and the supervisory work undertaken by the European Securities and Markets Authority (ESMA) in relation to closet tracking. The complaint made by investor groups is that index hugging constitutes a form of mis-selling because, taking into account the higher management fee, the investor ends up being significantly worse off than if they had invested in a lower cost index fund.
We summarise the recent developments in Europe below and explain why, in our view, this is an issue that UK based asset managers may want to start looking at more closely.
Background
In 2014 a class action was filed against Sweden’s second-largest fund house, Swedbank Robur, in relation to allegations that it had mis-sold investors closet index trackers. The action was initiated by the Swedish Shareholders’ Association (SSA) and more than 2,500 investors signed-up to the lawsuit. Ultimately, the action was dismissed by Sweden’s National Board for Consumer Disputes, who held that they, as a Board, did not have the appropriate authority to hear the case. It has been reported that the SSA is appealing that decision and is assessing other available options as regards seeking compensation for investors.
In January this year the Norwegian Consumer Counsel announced that it will be seeking compensation for 137,000 investors in a fund managed by DNB Asset Management, which has been accused of being a closet index tracker. The body is planning to pursue a class action against the asset manager or launch a legal claim as a pilot case on behalf of one representative consumer on the grounds that investors paid for a service they didn’t get.
In February 2016, ESMA published a statement providing details of its supervisory work on closet index tracking funds. ESMA began its investigation of the asset management industry as a result of concerns that the practice may harm investors who may not receive the service or risk/return profile to which they agreed based on the fund’s disclosure documents. From ESMA’s initial sample analysis of 2,600 funds for the period 2012-2014, it concluded that between 5% and 15% of equity funds could potentially be closet trackers. The statement concluded that “the potential practice of closet indexing in Europe raises questions that merit closer analysis”.
A concern for UK based asset managers?
Two recent Financial Conduct Authority (FCA) announcements suggest that index hugging is likely to fall within the scope of its current work:
In its 2015/2016 business plan the FCA states that it will be conducting a review to see whether “UK authorised investment funds and segregated mandates are operated in line with investors’ expectations as set by marketing material, disclosure material and investment mandates.”
In its Asset Management market study Terms of Reference, the FCA has stated that it will consider charging structures for providing asset management services in relation to both active and passive mandates.
The outcome of both the review and the market study, which are expected to be completed by 2016/2017, may well signal whether index hugging is an area of focus for the UK regulator. However, the Investment Association in its February 2016 Regulatory and Legal update, stated its view that both of aspects of the FCA’s work are likely to touch upon index hugging.
In the event that index hugging is highlighted as a matter of regulatory concern in the UK , there is no reason to believe that mis-selling claims equivalent to those currently being considered in Scandanavia would not follow in the English courts. We anticipate that any such claims would be brought on the following bases:
claims for breach of statutory duty pursuant to section 138D of the Financial Services and Markets Act 2000 (FSMA), and/or
claims arising from misrepresentations.
Key issues for consideration
We consider there are two key issues to consider now, which may provide some protection to UK based asset managers going forward:
One of the fundamental issues arising from ESMA’s review is whether or not the metrics it uses to determine whether or not a fund is “active” are appropriate. Whilst that may seem of little importance now, it is easy to see how, left unchallenged, it could over time (and through various regulatory endorsement) become the accepted industry benchmark. Based on our discussions with clients, our understanding is that those metrics are not broadly accepted and, in fact, may result in a large number of funds being unfairly tagged as “index hugging”. Given that risk, it may be a good time to consider whether, and to what extent, there may be value in liaising with various industry bodies in order to put collective pressure on ESMA to use more acceptable metrics.
It may also be prudent for asset managers to re-consider the statements made in relevant marketing and disclosure documents in order to assess to what extent (if at all) an increased focus on the issue of index hugging might expose them to a risk of investor claims in the future.
