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* Swedish regulator names 25 funds but issues no penalties
* Peer regulators also looking for 'index huggers'
* Britain's FCA in focus after tough report on industry
By Simon Jessop, Mia Shanley and Terje Solsvik
LONDON/STOCKHOLM/OSLO, Jan 12 (Reuters) - Scandinavia is raising the pressure on financial regulators across Europe to get tough on allegations of "index hugging" - where active investment funds may be misleading clients by covertly tracking a stock index.
Sweden's financial regulator has named 25 active funds run by some of the region's biggest providers which appeared largely to mirror benchmark indices, while in Norway a consumer watchdog is seeking compensation for investors from the asset management arm of DNB - a lawsuit the bank is contesting.
Consumers have long suspected that some active funds, which charge higher fees to scour markets for the best stock picks, may be "closet" trackers - offering little more service than cheaper passive funds which hold shares merely according to their weight in the underlying index.
Last year the European Union's securities regulator said up to 15 percent of active funds seemed to mimic their benchmark. Watchdogs in Britain, Germany, Denmark, Sweden and Norway have all looked into the issue, but few have revealed full details of their investigations and no asset manager has yet been forced to compensate investors.
Now the lead given in Scandinavia may encourage more European regulators to go public, even though index hugging can be difficult to prove.
Amin Rajan of CREATE Research said central banks' policies of flooding their economies with cash, much of which has ended up inflating stock prices generally, has made the problem worse.
"The regulators are likely to adopt a much more muscular approach, because the extent of closet tracking has reached a high proportion of funds as managers have found it difficult to beat their market benchmarks," he said.
By tracking an index, an active manager is less likely to stand out as a poor performer and lose clients. But the investor is paying extra in the hope that the manager will outperform the index, not just track it; active funds typically charge 0.75-2.0 percent of assets they manage a year, compared with as little as 0.1 percent for a passive fund.
The main measures in question are active share - the percentage of a fund's portfolio that differs from the underlying index - and tracking error - the difference between its returns and those of the benchmark.
When Sweden's Finansinspektionen (FI) regulator published its list in November, it named funds whose composition apparently closely replicated the index on which their performance was measured. They included offerings from Handelsbanken, SEB, Swedbank Robur and Skandia.
Carl Cederschiöld, CEO of Handelsbanken Asset Management, said its funds on the list have an active share above or in line with competitors. "We think this is fair to investors," he told Reuters.
SEB said it had merged two of the funds named by FI and that the new product had a significantly higher active share of above 50 percent. To improve transparency, SEB was publishing active share figures monthly, a spokeswoman for the bank added.
Swedbank Robur said its funds have been actively managed and that it has openly shown various risk figures for them. Skandia declined to comment.
FI's list followed pressure from shareholder groups which wanted the regulator to crack down on the behaviour and be clear about which funds were less active.
However, it did not refer to the funds as index huggers, even though most had active shares below the 60 percent defined as the minimum level by some academics.
Since its report, based on an investigation which began in 2013, FI has said activity in many of the funds has gone up while fees have come down, declaring itself happy as long as they are clear with investors and charge them accordingly.
"It's important that they take their activity and information they give about the fund and put that together - does the information about the fund match our activity level? What would a client expect?" said Erik Lindholm, deputy director for consumer protection at FI, told Reuters.
The Swedish Shareholders' Association said it had not taken any legal action on index hugging due to the high cost and uncertain prospects of success. However, in neighbouring Norway, a court ruled last week that it would allow a class action suit to go ahead against DNB Asset Management.
Norway's Financial Supervisory Authority found in 2015 that DNB had failed to provide sufficiently active management of a flagship fund, even though it had been marketed as such and customers had paid higher fees than for index funds.
At the time, the FSA ordered DNB to cut the fund's fees or ensure it was actively managed. The bank responded with changes to ensure the fund could continue to be classified as active, but has also reduced fees, which it said was a response to growing competition.
In the lawsuit, Norway's Consumer Council, a publicly appointed watchdog, will demand repayment of about 690 million crowns ($80 million) on behalf of 180,000 investors. The court did not rule on the merits of the case itself.
"We believe DNB charged their clients for a service they didn't deliver," Consumer Council chief Randi Flesland told Reuters. "In our view, they must repay the extra fee."
DNB has repeatedly argued the fund was actively managed, and rejected the compensation claim. A spokesman told Reuters the bank is now considering whether to appeal the court's decision.
To take action, regulators have to prove index hugging but some regard the active share and tracking error measures as too blunt to be fair.
"At this stage, naming and shaming is all that they can do because it's very difficult to define what active investing actually means and at what point an active portfolio turns into a closet-indexing portfolio," said CREATE Research's Rajan.
"But if the problem gets more widespread, I think we'll see some enforcement actions," he added.
Rajan pointed to an interim report from the UK Financial Conduct Authority which said fund investors were getting poor value for money due to insufficient competition and a lack of transparency on fees. "All that sound and fury means they've really got to back it with action," he said.
The industry is defending itself. A report from the European Fund and Asset Management Association in July said a wider range of factors needed to be considered, including a fund's objectives, the degree of risk tolerance and the research efforts of the manager.
The British FCA said in April that while most funds were doing what they said they would, it had found examples of those with unclear product descriptions and had told them to improve.
After a 10-month investigation, Germany's Bafin regulator, highlighted a couple of cases in December, but said the funds in question were already charging lower fees and were not being actively marketed.
In Denmark, a report in April found funds at 22 banking departments had active shares below 50 percent and tracking errors under 3 percent. However, it declined to name the funds and, after talking to them, decided no action need be taken.
Denmark's fund trade body has told its members to publish active share and tracking error figures annually, however, and an official at the regulator said it now looks at this on a case by case basis, without giving details.
Bafin has also said it plans to new transparency rules from mid-2017 so funds must give investors greater information about their style of management, while Sweden may also follow suit. ($1 = 8.6231 Norwegian crowns) (Additional reporting by Huw Jones in London, Andreas Kroener in Frankfurt and Jacob Gronholt-Pedersen in Copenhagen; editing by David Stamp)