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Lessons from Scandinavia

Updated: May 17, 2022

The fund industry is not like other industries. With most consumer products, you know what you are getting. Furthermore, if they break, you can get them fixed. This is not the case with investment funds.

"This is the approach Scandinavian countries have taken"

Actively managed funds are required to state a performance objective, but there is never any certainty that they will achieve it. Moreover, if they fail to deliver, you cannot get your money back. With passive funds there is far more certainty, but the certainty of index performance can cause investors to overlook the risks associated with the performance of the index itself.

Second, there may come a time when such a huge amount of money is managed on a passive basis that it distorts market prices significantly. This would make it easier for active funds to identify cheap investments and outperform indices and the passive funds that track them.

Third, there may be technical issues with passive funds that could affect their ability to deliver index returns. These include use of derivatives either to produce synthetic returns or get exposure to the underlying assets.

Under the aegis of the Financial Conduct Authority, PRIIP manufacturers are now required to produce Key Investor Documents (KIDs). These present information in a standardised form that is supposed to help potential investors and their advisers make well-informed choices with respect to fund selection. The problem is they hinder not help.

KIDs require PRIIP manufacturers to set out future performance and risk measures has the prescribed methodology thrown up some absurd predictions but also, perhaps more importantly, the whole idea of basing future performance on past returns blatantly flies in the face of that ubiquitous disclaimer we all know and love.

With respect to actively managed funds, I would prefer to see the regulator talking more about value for money and less about costs, then finding simple ways to guide investors away from those that are unlikely to offer value for money and towards those that can.

Indeed, this is the approach Scandinavian countries have taken. Both Sweden and Norway have put pressure on financial regulators across Europe to expose ‘index hugging’, the practice of charging high fees for what is essentially a passive service. Sweden has named 25 active funds that appeared to be doing just that; while in Norway a consumer watchdog has demanded compensation for investors in funds managed by DNB’s asset management division.

For active fund managers, outperforming an index is a two-step process. First, funds must be structured such that they have the potential to outperform. Second, they must employ an investment style designed to achieve this potential.

With respect to the former, the more a fund mimics an index, the less likely it is outperform it on an after costs basis – think about an active fund that is exactly the same as its index, then charges active fees. Funds need to be sufficiently different to their indices to be able to give themselves the chance of beating them. Moreover, performance in line with benchmark index should not be considered good enough. After all, you can get that from a passive fund so why take the extra risk? I believe funds should aim for outperformance that is 3-4 times management fees.

There is no agreed best way of investing, and it would be wrong for regulators to suggest one style over another. However, this should not stop them from doing nothing. One suggestion would be to require asset managers to disclose standardised calculations of how different their funds are to their benchmark indices, thus providing a guide as to outperformance potential.

Active share and tracking error are examples of simple measures that could achieve this, and both can be calculated objectively and thus in a standardised format.

Based on the regulator’s current form, however, I am not optimistic.

Published in What Investment

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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