Closet Index Funds – Caveat Emptor or Caveat Venditor?

Date: March 20, 2015

Ever since the first index mutual fund was launched 40 years ago, the debate between passive and active advisors has raged. The fees for active management are significantly higher than the fees for passive management. Which is as it should be, since active managers earn those fees by providing above market returns, right?

Well, some do and some don’t. Or, more accurately, some do and most don’t. According to S&P’s 2014 Mid-Year 2014 SPIVA U.S. Scorecard, over the past five years, the best performing U.S. equity asset class was small cap value, where 78.32% of the funds did worse than the market (S&P Small Cap 600 Value Index). So in the best performing asset class – the best – only 21.68% of actively managed funds justified their fees. The other asset classes were far worse, with well above 80% or even 90% of the funds underperforming.

The performance relative to the market for most actively managed international equity asset classes is about the same as U.S. equities over a five year period. Fixed income classes did the best, with about half of them earning those high fees.

Investors are responding accordingly. The 2014 ICI Factbook reported that between 2007 and 2013, equity index funds experienced $795 billion in net inflows, while actively managed equity funds had net outflows of $575 billion.

The poor active fund track record, especially in equities, is a bit of old news. However, there is a more recent development that goes beyond the value of active management and into false advertising, and away from investors making their own choices and towards regulators potentially taking a more active role in those choices.

To what extent is an active manager even trying to beat the fund’s benchmark? Is the manager running a so called “closet index” fund? Are they claiming active management so that they can charge higher fees, but are in fact just phoning it in by tracking an index?

On the heels of a review started by Denmark last year, Sweden recently announced that they will be conducting a review of active managers to find out which ones are closet index trackers. ESMA is looking into a similar initiative, and Norway recently singled out an asset manager and asked that they either start actively managing or reduce the fund’s fees.

Certainly, if the fund is hiding their activity in order to take advantage of retail investors, it is appropriate for regulators to step in. But that isn’t really happening. There are some pretty obvious ways to tell if a fund is a closet index. Much like a food label telling you how many calories are really in that supposedly healthy snack, risk statistics such as active share, tracking error, r squared, and beta shine the light on which funds are providing alpha and which ones are simply riding the market’s coat tails. Even without these more sophisticated tools, simple returns usually do the trick, as the capital outflows from active funds indicate.

If all of this information is readily available, is it really false advertising? If investors are voting with their feet, as the inflows and outflows show, isn’t that an indication that they are capable of evaluating their own investment choices? Since mutual fund “food labels” exist and since all the information investors need to determine if an adviser is earning their management fees is out in the open, aren’t closet index trackers already out of the closet? Isn’t the regulator’s job complete before it ever began?

Hopefully these European reviews will result in nothing more than what everyone is doing anyway–disclosing returns, disclosing risk statistics and maybe a little extra investor education on the side, which would be a good thing. However, as a smart man once told me, regulators have yet to meet a regulation they don’t like, so I won’t hold my breath.


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