When the rest of the world is moving to indexing, why a "closet index" portfolio of actively managed funds might make sense for Irish investors

“In reality much more money is passively managed, it’s just that people are paying active management fees for passive management. For example, if you take a big pension fund, it has many different managers who are all being paid to produce active management. When you look at the overall portfolio it might look very much like the market. So, what they have decided to do is to pay 1% to buy the market. I never quite saw the logic in doing that. There is much more effective indexing than we see by looking at how money under management is allocated by looking at active vs. Passive”. 

Eugene F Fama, Nobel Prize in Economics 2013

We see a perfect illustration of the point Professor Fama is making in the graph below where we compare the performance of say, the Irish Life Consensus Fund with the FTSE All World Equity Index. We can see, just by looking at the graph, that the two are highly correlated, that is to say they tend to move together. 

Gross Return Bid-Bid line chart for 10 years since start of data, 22 Nov 2001, of Irish Life Consensus S1 Fund and FTSE ALL-WORLD INDEX from Ireland Insurance Gross universe. Rebased in Euros Data provided by FE.

Our analysis over this period of a decade indicates that the two funds were actually 96% correlated with each other and therefore tend to move together almost in perfect "lock-step".

Since it is possible to purchase a Global Equity fund from, say, Vanguard with a Total Expense Ratio of just 0.15% one might question why would anyone ever buy an actively managed fund?

However, in an Irish context, the main reason for our desire to deviate from the simple logic of investing in low-cost index funds is in order to achieve a particular tax treatment.

The point we wish to make here is this; if we purchase a broad spread of fund managers, a consensus if you like, we can expect the resulting portfolio to look pretty much like the market -we call this "closet indexing" and whilst the Central Bank of Ireland recently shone a light on this practice in the negative context of investor disclosure, we believe that sometimes this can be a great strategy especially when combined with an investor's personal tax status for example a low relative income and/or capital gains tax losses.

Our closet-index portfolio compared to the Dimensional World Equity Fund

Source: Morningstar

Here, we are using a "closet index" approach in order to generate a "similar" expected return to a globally diversified UCITs fund gross of tax, but in an Irish context, with the potential to deliver a better return for a taxable investor.

We also have an Socially Responsible and Ethical Version of these portfolios which we benchmark against the Vanguard SRI Index fund, again with similar results.

 Summary

· In an Irish Context, these portfolios have a particular tax treatment which may be attractive for Irish investors outside of a pension fund.

· We intentionally design a closet index "market-cap" weighted portfolio from active managed funds rather than index funds.

· The gross expected return (even allowing for the higher costs) is broadly the same as the index

· The net of tax return is up to 4%pa higher for certain Irish investors depending on their personal tax status.

See our tax guide for further analysis

For educational and information purposes only

Nothing in this article is intended to be or should be construed to represent a “scheme” that would require disclosure under the mandatory disclosure regime.

Nothing in this article should be construed to represent either financial advice or tax advice