image source: abovethelaw.com

Recently, a new study has been published by Yale University’s Antti Petajisto that is designed to measure how much a mutual fund’s holdings match a benchmark index (such as the S&P 500, for example.) Funds that deliberately track the holdings of an index are called an “index funds,” an investing strategy is known as “passive investing.”

In contrast, funds that hold widely different positions from the index are called “active” funds, because the managers are actively choosing investments they think will outperform the index, based on their analysis of business and economic conditions. While both active and passive are valid ways to go about investing, our clients know that we favor the active approach. In fact, the study points out that during the study period, the most active funds outperformed by over 1% per year net of fees. However, regardless of whether you favor active or passive investing, there is one type of mutual fund that investors will certainly want to avoid…these are known as “closet index funds.”

So what is a “closet index” fund? This is a fund that markets itself as an active money manager, but holds remarkably similar investments to the benchmarks they are trying to beat. The study found that these funds under-performed their benchmarks by an amount similar to their fees. That makes sense, because if they hold similar investments to the index, you would expect their gross returns to be similar to the benchmark. After fees, then, they should under-perform.

There are many reasons why funds become closet indexers. Maybe they simply want to minimize the risk of losing assets. Perhaps they started out as truly active funds and had good returns, but then as assets grew they became complacent, preferring to not take risks that could cause investors to jump ship. Or as fund assets grew, perhaps the fund became too large to invest in just a few select stocks (e.g. market liquidity couldn’t support having a concentrated portfolio). Regardless the reason, closet indexing begs the question: why pay higher fees for active management, if you aren’t actually getting active management. There are plenty of index funds one can buy with very low expense ratios. In theory, the only reason you pay higher fees is because you want a talented manager’s skill and best investment ideas. By that measure, then, a closet indexer could be said to be “ripping off” his or her investors.

What does a closet index fund cost to investors? This is a simplistic example, but I think it makes the point: let’s say a fund holds exactly the same investments as the index in one half of the fund, and the other half represents the manager’s best ideas. And let’s say this fund charges 1% in annual fees. What this means is that the actual fee for the manager’s investment ideas is 1% divided by one-half (the part that represents his ideas), which equals a 2% annual fee. So the investor is paying 2% in fees for the piece of that fund that the manager is actually investing. That’s a pretty steep expense ratio!

This is the first of several posts on mutual funds, and I plan to give more examples next time.

Here are a couple of links that may be of interest: