This entry was written for www.etfmarketpro.com
For many, the benefits of creating a long term diversified index portfolio are well known. In fact the emergence of ETFs, with their easy access to small cap international, emerging markets, commodities, foreign currency, and many other hard to reach asset classes, has helped passive indexers achieve more diversification and many index professionals achieve higher returns. I have seen a resurgence this past year in the active versus passive debate, due to the S&P 500 having a negative 10 year track record. On our news media outlets, the defenders of passive investing always seem to refer to the dilemma of buying and holding individual securities vs. actively trading securities. However, there is also a debate on whether to buy and hold index funds or buy and hold mutual funds. Active fund managers want you to believe that they can always time the market's ups and downs and that, for the most part, they will pick winning stocks. This is absurd, of course, but many individual investors, confused by all the debate and different investing schools of thought, fall for the sizzle of short term performance without thinking of long term results.
There is an old joke that financial news journalists write about the hot stock or mutual fund by day and privately invest in long term healthy index funds by night. Could this be true of active fund managers as well? This is where the term “closet indexer” comes from. A closet indexer is a fund manager that mimics the index, or benchmark, that he or she is assigned to outperform. For example, if a fund manager has the same holdings as the S&P 500, thus the same performance, the manager would be a closet indexer. The problem here is that the investor is probably paying 50bps (0.50%) or more for the performance, and thus would have been better off buying the S&P 500 index, SPY, or the Vanguard S&P500 index mutual fund equivalent with fees less than 1/10 of a percent.
Job security and fund size are two major reasons why a fund manager would mimic its assigned index. Fund managers have their performance measured quarterly, so they do not want to stray too far from their assigned index. While they may take additional risk at times to attempt to make up for their fees or try to outperform the market, the overall portfolio is invested in the same sector percentages as the index. The idea is that fund investors would not pull their money out for poor performance if the fund manager performed near the index or his or her peers.
The size of the mutual fund may also push the manager towards being a closet indexer, since only so much can be invested in companies that the manager sees as outperforming the market. The remainder of the fund’s assets are then invested in securities that match the index so that overall performance versus the index will not go awry.
Closet indexers are fairly easy to spot. The most common way to find one is to take the R Squared of the fund. R Squared is a statistical measure that represents the percentage of a fund or security's movements that can be explained by movements in a benchmark index. For example if a fund has an R Squared of 97, then 97% of its movements matched that of its assigned index.
A search within Morningstar’s database of 24,900 open ended mutual funds for a 10 year R Squared greater than 96 and fees greater than 0.50% found 742 funds. In most cases, an ETF should not cost you more than 35bps (0.35%), but I gave the fund managers the benefit of the doubt by searching for management fees greater than 50bps (0.50%). This means that 3% of all open ended mutual funds perform no better than their assigned index over a ten year period and cost double what they should.
When I dropped the R Squared to 95 or greater, 1,723 funds were returned, making 7% of open ended mutual funds subject to our closet indexer title. I then looked for an R Squared of 97 or greater over the last 12 months with a management fee greater than 0.50%, and the return increased greatly. 5,377 funds were returned, making 22% no better than the index itself.
As you look at your mutual fund, you have to take into account the cost of active management. Maybe your manager beats the market by a few percentage points, but what kind of fees do you have to pay for this performance? Is the net performance near the index returns? Is your fund manager a closet indexer?
This New Year, you should resolve to consider putting your portfolio on a diet and look at the benefits of low cost Exchange Traded Funds (ETFs).