Closetindexing

Key Takeaways

• Closet indexing is when funds claim active investment but closely mimic a benchmark index.
• It's often criticized due to high fees for fund management that only mirrors index funds.
• Tools like R Squared and active share reveal a portfolio's deviation from its benchmark.

What Is Closet Indexing?

Closet indexing is when a fund purports to actively manage investments but closely mirrors a benchmark index like the S&P 500, leading to near-similar returns. Investors are curious about closet indexing because it impacts their fees and overall returns, often resulting in dissatisfaction due to higher charges for quasi-passive management. Because of the shift from active to passive management, closet indexing has gained attention.

Understanding the Mechanics of Closet Indexing

Closet indexing might stick to an index in terms of weighting, industry sector, or geography. A manager's performance is usually compared to a benchmark index, so there is an incentive for managers to gain returns that are at least like the index. Even if the fund performs slightly worse than the benchmark net of all fees, the manager is touted for their stock-picking ability.

Closet indexing is often viewed negatively by investors because they could simply choose an index fund and pay lower fees. On the surface, it might be difficult to identify if a fund practices closet indexing but a closer look at the prospectus can uncover a fund's true holdings. There are a few ways to spot funds that replicate a benchmark index.

Tools like R Squared and tracking error determines a portfolio's statistical deviation from the benchmark index. R Squared is by definition a statistical measure that represents the percentage a fund deviates or conforms to a benchmark. Meanwhile, tracking error depicts the difference between a fund's returns and the benchmark, otherwise known as active risk. Another metric to look at is the active share, which establishes the percentage of holdings that differ from the benchmark index. A portfolio with an active share between 20% and 60% is considered a closet indexer.

20% to 60%

The range of an active share reflecting a closet indexer.

The Downsides of Closet Indexing

The biggest issue investors have with closet indexing is the high fees that active managers continue to charge, despite taking a passive approach. Investors wind up taking the brunt of this indiscretion because they pay higher fees for similar or mediocre performance. However, choosing a fund with a high active share won't necessarily translate to better returns. In the end, active funds that beat benchmark returns tend to have lower fees than the traditional actively managed fund.

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