‘Closet indexing’ refers to practices where a fund claims to attempt to beat the market, despite following a passive investment strategy in practice. Such practices may harm investors, who might end up paying higher fees than necessary while not receiving the service they expect.
In the course of the recent years, several European regulators have identified widespread index hugging practices. In 2016, the attention of the European Securities and Markets Authority (ESMA) was drawn to the alleged practice of closet indexing in the European collective investment management industry. ESMA examined roughly 2,600 funds active from 2012 to 2014 and found that between 5 and 15% of funds claiming to have an active investment strategy were actually tracking the market.
In 2015, as part of its supervision of management companies, the Norwegian Financial Services Authority investigated whether Norwegian collective investment funds that were marketed and priced as actively managed funds were in fact managed as such. It concluded that Norway’s largest financial institution (DNB) had failed to provide sufficiently active management of funds.
This led to the Norwegian Consumer Council (NCC) filing a class action suit on behalf of 180,000 investors. The road to redress has been long for Norwegian investors, but on 28 February 2020, the Supreme Court of Norway concluded that DNB must repay approximately 350 million NOK (circa 35 million EUR) to Norwegian investors.
The Supreme Court concluded that the investors’ legitimate expectations of the degree of active management differed from the actual management of the funds.
The investment objective was described as follows in the prospectus: ‘DNB Norge’s objective – relative to the fund’s benchmark index – is to achieve the highest possible return on the fund’s investments. The fund’s investment index: Oslo Børs Mutual Fund (OSEFX). The index is dividend adjusted. The fund is suitable for businesses and individuals wishing to invest in Norwegian equities and preferring high risk and a high level of freedom in fund management.’ The Supreme Court concluded that the description in the prospectus provided a clear impression that the fund was to be actively managed.
The Supreme Court also examined the cost of fund management. The management fee was 1.8% pa, while DNB also had security funds under passive management with a management fee of 0.3%. Actively managed funds typically charge higher fees than index funds. These fees are justified by the higher research and trading expenses incurred by funds with actively managed portfolios. The added expenses of an actively managed fund can only be offset if the portfolio is in fact different from the market, ie, the fund is actively managed. The Supreme Court concluded that when the management fee is in line with funds that are actively managed, this justified investors’ expectations of active management.
Based on an overall evaluation of investor information documentation and the cost of the management service in light of the asset manager’s general responsibility to act in the investors’ best interests under the UCITS regime, the Supreme Court concluded the investors had legitimate expectations that the fund should be actively managed. Because the fund had in fact been managed virtually identically to its benchmark index, the Supreme Court concluded that DNB failed to deliver the service their customers paid for.
The legal grounds for the claim were rules on price reduction under general Norwegian contract law. The investors paid for active management, but in fact got the cheaper service of passive management. Hence, the fund manager was required to repay part of the difference in price between passive and active management. The management fee was reduced from 1.8 % pa to 1.0 % pa.
More about this case, experiences with closet indexing in Scandinavia and closet indexing in general can be found in my article ‘Closet Index Funds and Retail Investor Protection – A Scandinavian Perspective’.
Marte Eidsand Kjorven is an associate professor at the Faculty of Law, University of Oslo.