Pulling the curtain on “closet indexers”

The OSC’s latest annual report from the regulator’s investment fund and structured products branch, released in February, revealed that it’s undertaking a targeted review of mutual funds that claim to be actively managed in their marketing materials and prospectuses. The OSC effort aims to determine whether these funds are being actively managed or are just tracking their benchmark.

“Benchmark hugging” or “closet indexing” is a concern to regulators for several reasons. For one, investors typically pay much more for mutual funds that promise active management than for passively managed products in the hope a shrewd active portfolio manager can outperform the benchmark. Yet, if unitholders of funds purporting to be actively managed, but are receiving only passive management, then those investors are overpaying. They may as well be paying much lower management fees for an explicitly passive product.

The advent of low-fee exchange-traded funds (ETFs), which track an index for just a handful of basis points (bps) in fees, makes this concern even more acute. Why should investors pay more than 2% for active management from a closet indexer when they could get the same return from an index-tracking ETF for less than 10 bps? This issue is particularly significant in this low-return environment, in which the costs of investing increasingly are critical to investors’ portfolios.

In addition, that a mutual fund may be promising active management yet merely providing index tracking is a concern for regulators because this closet indexing may harm investors’ portfolio construction.

The risk/return profile that investors and their financial advisors are trying to create could be undercut if the products being used to build the portfolio don’t deliver what those products’ marketing materials and regulatory filings say their portfolio managers do. Moreover, the prevalence of closet indexing is a signal of the health of the mutual fund industry overall.

According to a paper published by four academics who looked at the suspected incidence of closet indexing around the world in 2013 (The Mutual Fund Industry Worldwide: Explicit and Closet Indexing, Fees, and Performance, by Martijn Cremers from the University of Notre Dame, Miguel Ferreira of the Nova School of Business and Economics, Pedro Matos of the University of Virginia, and Laura Starks of the University of Texas at Austin), high levels of closet indexing indicate little competitive pressure within the mutual fund business. A high proportion of openly passive portfolio managers is associated with stronger competition and greater industry efficiency overall.

Typically, mutual funds with an “active share” – the percentage of a mutual fund’s portfolio that deviates from the securities that make up its underlying benchmark – of less than 60% of the portfolio are considered to be possible closet indexers. Using that threshold to define closet indexers, the academics’ study found that the practice is widespread in much of the world, particularly outside the U.S.

For example, the study found that in Canada, 37% of assets under management (AUM) promise active management, but just track their benchmark. This proportion was much higher than the global average of about 20% overall (30%, if excluding the U.S.). Furthermore, the study found that the incidence of closet indexing is particularly high for domestic funds in Canada, with more than half (56%) of AUM being run by apparent closet indexers.

The problem of closet indexing appears to be particularly acute outside the U.S., as mutual fund portfolio managers in smaller markets may have a harder time deviating from their benchmark even if they want to, simply because there may not be enough stocks to choose from.

The academic report notes that by simply looking at active share, distinguishing between portfolio managers who are content to track their benchmark and those who try to manage their portfolios actively but end up sitting on the benchmark is impossible.

The OSC’s report, in turn, indicates that the regulator’s effort to assess the prevalence of closet indexing in Canada began by examining the active share of mutual funds that claim to be actively managed. Based on that initial assessment, the OSC has followed up with certain Canadian equity fund portfolio managers, seeking more information about their investment strategies and why their portfolios appear to “overlap significantly” with their benchmark.

The OSC now is in the process of reviewing the portfolio managers’ responses and requesting further information, including whether the “managers’ evaluation of their funds’ performance relative to their benchmark index” is influencing their stock selection process.

What Canadian regulators can do about closet indexing is another question. Although they want portfolio managers to be truthful with investors, distinguishing between portfolio managers who want to be active, but are failing, from those who aren’t even trying may be trickier.

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