Combating Closet Indexing – A new approach developed by the FSMA

Press release
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Closet Indexing refers to the practice of promoting an investment fund as actively managed, whereas in fact the fund closely tracks a benchmark index. The Financial Services and Markets Authority (FSMA) has developed an innovative methodology to detect possible Closet Indexers on the Belgian public investment fund market.

Closet Indexing: a practice that is disadvantageous to investors

This practice is disadvantageous to investors, since, on the one hand, they do not receive the active management described in the fund’s investment policy, while on the other hand, they pay higher fees than those charged for passive management. Therefore they are receiving passive management for the price of active management.

An innovative approach developed by the FSMA

Previous analyses conducted at European level by ESMA with a view to detecting potential Closet Indexers focused only on share funds (37% of the market). The importance of mixed funds (42% of the market), which invest in both shares and bonds and, to a lesser extent, in bond funds (6% of the market), on the Belgian public investment fund market prompted the FSMA to expand the scope of analysis.

The FSMA therefore developed, with its Data Analytics Expertise Centre, an innovative methodology to detect potential Closet Indexers. This methodology can be applied to all funds, whatever their investment policy (shares, bonds or mixed).

In order to do so, the methodology compares the performance of funds with the performance of combinations of indices. Working with combinations of indices makes it possible to expand the scope, since many funds, and especially mixed funds, use multiple indices (e.g. an index for the share component of the portfolio and another index for the bond component). This methodology requires highly effective analytical tools, since there is a very large number of potential combinations of indices (depending on the indices used and the weighting among them).

No Closet Indexer was detected…

This methodology was applied to the Belgian public investment fund market. The quantitative analysis revealed a number of potential Closet Indexers. The subsequent qualitative analyses showed that these were not in fact Closet Indexers. At the end of the analysis, no Closet Indexer had been identified, which is good news for investors.

…but 4 funds were insufficiently transparent

In the case of 4 funds, the FSMA carried out an in-depth analysis, based on internal documents that had been made available to it. This analysis made it possible to determine that the 4 funds in question are managed with reference to an index, but that this is not stated in the information provided to clients.

These are not cases of Closet Indexing, however, since the intention is not for the funds to closely track that index. But the fact that the funds use an index, for example, when the objective is to outperform that index, should be communicated to investors. The 4 funds will update their documentation to reinforce transparency vis-à-vis investors.

Vigilance remains advisable

The methodology that has been developed is an additional tool available to the FSMA to ensure that this practice is not adopted in our country. Analyses of this type will therefore be conducted on a regular basis.