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How to prove your UCITS Fund is not Index Hugging

With more than 2,000 Irish investment funds facing into Central Bank of Ireland (CBI) investigations to ensure they are not misleading customers about charges and other issues it’s important to ask how these firms can best provide regulators with the proof that they need.

The CBI investigations into UCITS funds have been sparked by concerns raised by the Paris based European Securities Markets Authority (ESMA). Yet this is not a new area of concern for the CBI. The CBI’s 2016 report sought to ensure that customers were not misinformed about UCITS’ investment policies and charges. As a result UCITS funds are well briefed on the concerns of the CBI.

The CBI recently announced, of particular concern is “closet indexing” or “index hugging”. This is where the fund managers falsely claim they invest actively to get better returns than those offered by stock exchanges, but in fact they take a more passive approach and track a benchmark index which in turn results in returns matching those of the markets.

As there is more work for an active fund manager to actively place trades to generate higher returns, they can charge higher fees. A passive strategy which simply keeps pace with stock market returns requires fewer trades, and therefore means that the manager should charge less. The CBI is investigating if this is indeed being carried out in practice.

The burden of proof is on the fund manager. They must be able to show that they have been actively trading and can use best practice techniques such as automated trade monitoring and auditing software to prove that they are not merely tracking the index. Savvy fund managers will take this a step further and provide data visualisations to the CBI that show fund performance when compared to an index benchmarks and additional automated data insights that show the variances between the fund and benchmark. It is clear that technology is the solution to the now ongoing burden of proof that UCITS fund managers face.

With 2000-plus Irish domiciled UCITS funds to investigate the task facing the CBI is by no means insignificant. It is therefore likely if the regulator finds proof of “index hugging” it may use all its powers, which include ongoing supervision and sanctions such as fines. For this reason UCITS fund managers need technology to lessen their burden of proof and maintain a good relationship with their regulator.