Shining a light on “closet indexers”

“There is a lot of similarity to the market indices, especially with large-cap equity mutual funds in the U. S. and Canada,” Cremers says. “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 Cremers’ research of mutual funds in 30 countries, he found that although Canada has one of the largest mutual fund industries in the world, it has a high level of closet indexing, with 40% of all mutual funds described as closet indexers. Among Canadian equity funds benchmarked against the S&P/TSX composite index, Cremers says, about 70% are closet indexers.

Much of the industry data on the performance of mutual funds simply lumps together all funds, Cremers says, thereby making it difficult for truly active funds to illustrate the value they can have over index funds.

“We must move beyond the active vs passive debate,” he says, “and ask whether investors are truly getting active management when they buy a mutual fund.”

In 2009, while working as associate professor of finance at the Yale School of Management in Connecticut, Cremers and a colleague had developed an analytical measure for determining the difference between a mutual fund portfolio and an index, which they called “active share.”

A fund with a portfolio that is 80%-100% different from the securities represented in the benchmark 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%-60% range are closet indexers or “benchmark huggers,” and those in the 60%-80% range are considered “moderately active.”

Active share measures how a fund differs from its benchmark – in terms of both the names held in the portfolio and the percentages of assets under management (AUM) held in those names. A fund could have all the same names and vastly different weights as the index, Cremers says, and still achieve a high active share.

Cremers’ research over the 20-year period from 1990 to 2009 found high active share funds consistently have outperformed their benchmarks by more than 1.3 percentage points a year, net of fees.

Closet indexers, on the other hand, have underperformed their benchmarks by approximately one percentage point a year, which, Cremers says, is a reflection primarily of their additional management fees.

Smaller, more flexible funds tend to have a greater degree of deviation from the index than do larger funds.

“It’s hard for some managers to look different from the index,” Cremers says. “If they’re wrong for a period of time, they can lose assets, and that fear keeps many managers close to the index. But it’s the funds whose holdings are most different from their benchmarks that are truly active – as opposed to closet indexers – that outperform their benchmarks.”

Glen Gowland, chairman of the Investment Funds Institute of Canada, says there is room for both index investing and active management in a fund’s portfolio, and it’s important that financial advisors and their clients understand what they are buying and how it fits their goals, whether they’re looking for an index approach, a conservative portfolio with low volatility or a more aggressive style.

“It’s not difficult to see what’s in a fund portfolio, including the weightings, and how closely it resembles an index,” Gowland says. “There’s lots of transparency around these things, as well as the cost of management, other costs and the performance record of the fund manager. We are big proponents of disclosure, transparency and the value of advice in ensuring investors obtain the products that are appropriate for their goals.”

According to Cremers, the U. S. has one of the highest levels of actual index-based products, with 20% of investment assets managed by index funds and ETFs. But with only 10% of U. S. funds being described as closet indexers, the U. S. also has the lowest level of closet indexing among the 30 countries studied by Cremers – and U. S. active funds are, he adds, “effectively, quite active.”

Cremers’ findings suggest that as indexed funds and ETFs grow their market share, the competitive pressure on actively managed funds increases.

“For many countries with little to no explicit indexation, the actively managed funds domiciled in these countries are relatively passive, as measured by their active shares,” states the 2011 version of a report by Cremers entitled The Mutual Fund Industry Worldwide: Explicit and Closet Indexing, Fees and Performance. “Our results suggest that actively managed funds are more differentiated from their benchmarks in countries where there is stronger competition from indexed funds. In many countries, investors are paying higher fees to obtain what is actually passive management rather than receiving the benefits of truly active management.”

Closet indexing is rare for funds pursuing global investment strategies – and more common for funds with single country or sector benchmark indices, Cremers says, such as large-cap U. S. and Canadian equity funds.

Global funds typically are measured against a combination of benchmarks and the portfolio managers have a broader universe of stocks to choose from, he adds, leading to greater opportunity to deviate from a single index.

The 20 largest Canadian equity funds, with AUM ranging from $1 billion to $9 billion, have an average active share of only 57%, Cremers says, which means more than 40% of their AUM duplicates the index.

“The scope for being active vs the benchmark index,” Cremers says, “depends, in part, on the number of stock positions one needs to replicate the benchmark.”

For example, his study found the average active share is 81% for active funds tracking the MSCI world index but 65% for those tracking the narrower Dow Jones Stoxx 50 index, which tracks the 50 largest companies in Europe.

“Why not apply active management to a larger part of fund portfolios?” he asks. “What’s needed on the part of managers is not only skill but conviction and opportunity.”

The AUM in some funds is largely relative to the number of names in the available universe of eligible investments, Cremers says, and this acts as a constraint on some portfolio managers. Other funds are constrained by their sponsor’s rules or their investment mandate, in terms of how far they can deviate from an index. Sometimes, the market in which the portfolio manager operates is narrow – the TSX 60 is much more limited than the S&P 500, for example. In Canada, Cremers says, it’s difficult to stray too far from the index without investing in smaller companies.

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