Investors in actively managed mutual funds are paying higher fees than those in passively managed products such as index funds and exchange-traded funds, but frequently the funds they invest in are “closet indexers” that are unable to outperform after charging fees, says Martijn Cremers, professor of finance at the University of Notre Dame in Indiana.
“Research shows a lot of similarity to the market indices, especially with large-cap stock funds in the U.S. and Canada,” Cremers said in an interview in Toronto. “Outperformance can only come from the part of the portfolio that is different from the index. If only a small share of the portfolio is different, it’s going to be difficult to make up for the fees charged for active management.”
In his research, Cremers found that while Canada has one of the largest mutual fund industries in the world, it has a high level of closet indexing, with 40% of funds described as closet indexers. Canada also has a low level of official indexing, with only 2% of funds classified as index funds. Among equity funds benchmarked against the S&P/TSX Composite Index, about 70% are closet indexers, his research shows.
During a previous position as associate professor of finance at the Yale School of Management in Connecticut, in 2009 Cremers and a colleague developed an analytical measure for determining the difference between a fund portfolio and an index, and called it the “active share.” A fund with an 80% to 100% difference from the index is determined to have a high active share, while a fund with a difference of less than 20% is truly an index fund. Those in the 20% to 60% range are closet-indexers or benchmark huggers, and 60% to 80% are considered moderately active.
Active share measures how a fund differs from the index both in terms of the names in the portfolio, as well as in the percentages held in those names. A fund could have all the same names and vastly different weights as the index, and achieve a high active share, Cremers says.
Cremers’ research over a 20-year period from 1990 to 2009 found high active share funds consistently outperform their benchmarks by more than 1% a year, net of fees. Closet indexers, on the other hand, underperform their benchmarks by approximately 1% a year, which is primarily a reflection of their additional management fees, Cremers says.
“It’s hard for some managers to look different from the index,” Cremer says. “If they’re wrong for a period of time, they can lose assets, and that fear keeps many managers close to the index.”