How to Spot a Closet Indexer

How to Spot a Closet Indexer

It makes little sense to pay for active management that is not pulling its weight. Here’s how to tell if a manager is hewing too close to an index.

With expenses continuing to fall on exchange traded funds (ETF) and passively managed mutual funds, it’s hard to justify investing in an actively managed portfolio that isn’t pulling its own weight. It’s even harder to rationalize investing in an “active” fund that is simply mimicking an index but charging 10 times or more the expense ratio of an ETF to do it.

If your client truly wants an active manager who’s striving to outperform a benchmark, a closet indexer won’t fill the bill. Returns are likely to be similar to the fund’s chosen benchmark, only eaten down by costs.

Yet weeding out these “closet indexers” takes some time and diligence. It’s worthwhile, however, because both true active management on one side, and index funds on the other, may be a better option for your clients.

A reasonably good gauge to identify closet indexers is a fund’s correlation, or “R-squared,” which is available in most fund rating guides such as Bloomberg, Morningstar and Yahoo Finance. This measures how much of a fund’s movement is explained by changes in the underlying index. A perfect correlation to an index is 1.00. For example, the R-squared of the Fidelity Magellan fund, an actively managed portfolio, when looked at against the S&P 500, was 91 for the most recent three-year period measured by Morningstar; it beat out that index by 90 basis points during that time period.

An alternative, though less reliable, way to separate a closet indexer from an active manager is to look at their “active share” percentage.

Developed nearly 10 years ago by Martijn Cremers of the University of Notre Dame and Antti Petajisto of New York University, along with researchers at BlackRock, active share is a measure of how a portfolio’s composition differs from a benchmark index’s holdings. The closer the portfolio represents a common index—such as the S&P 500—the lower its active share, and vice versa. A passive fund that fully represents a benchmark index has an active share of zero. 

That means that active managers who have a low active share are likely to be closet indexers. One of the conclusions of the Cremers and Petajisto study is that active share can be a predictor of fund outperformance, based on their analysis of stock fund returns from 1980 to 2003.

“Active Share predicts fund performance,” the authors concluded. “Funds with the highest Active Share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence. Non-index funds with the lowest Active Share underperform their benchmarks.”

While actively managed funds also have a bevy of detractors, they may be stepping up their game where they have competition from pure and closet indexers. A recent paper by Cremers, 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 studied fund returns in 32 countries. Active funds showed better results in countries where index funds were available.

Yet active share may be difficult to find. Morningstar, for example, doesn’t include it on its Morningstar.com rating pages. Active share also doesn’t tell you detailed information about how a portfolio is constructed or how it “tilts” toward large-, medium- or small-company stocks, or a manager’s preference for growth, value, quality or momentum stocks.

The Trade-off of Taking on Risk

Yet once you know a fund’s active share and correlation to an index, you can put the question to your client (or make the decision yourself if you have the discretion): Which fund gives you the most bang for your buck?

While the presence of active share is an important distinction, you have to be careful. Being an active manager doesn’t guarantee better returns when compared to an indexer. In fact, only a handful of funds with winning records are able to persist in outperforming. Less than 10 percent of funds in the top quartile of returns in the most recent S&P Dow Jones persistence scorecard managed to stay in the top tier from September 2012 through September 2014.

There’s also the thorny matter of the trade-off of taking on more risk in active management.

In a paper published by Fidelity Investments last year, the authors warn that “greater levels of active share come with greater levels of return dispersion and higher downside risks,” and that “investors should be wary of trying to make precise distinctions about manager skill or return potential using active share alone.”

This translates to assessing whether the fund mimicking an index is worth a higher expense ratio than an ultra-cheap index ETF. Keep in mind that you can achieve market returns with a stock ETF charging as little as 0.04 percent annually, compared to around 1 percent for actively managed funds.

“If you’re going to be active, go with low correlation or low costs,” notes Larry Swedroe, director of research for Buckingham in St. Louis and co-author of The Incredible Shrinking Alpha (excerpted here).

As with everything in the fund universe, expenses are always subtracted from net returns, so the cheaper the fund, the better chance you’ll have of coming close to the benchmark. If your client doesn’t want to take a bet on underperforming in an actively managed fund, the better wager is to get as close to an index as possible. 

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