Avoiding Costly ‘Closet’ Index Funds

closet index fundsStockbrokers and other financial advisors are quick to promote expensive, actively managed mutual funds and the alleged benefits that such funds can provide over less costly index mutual funds. And yet, studies consistently show that actively managed mutual funds underperform index funds on a long-term basis.

Standard & Poor’s publishes an annual analysis comparing the performance of market indices to actively managed mutual funds. The analysis, known as the SPIVA Scorecard, consistently shows that actively managed funds underperform the market indices, on a long-term basis. The last year end report available, 2012, showed that on a five-year basis (2008-12) , 86.49 percent of large cap mutual funds, 90.22 percent of mid-cap mutual funds, and 83.05 percent of small cap mutual funds underperformed their respective indices.

With increasing public awareness of this persistent under-performance at a higher cost, many managers of actively managed mutual funds have adopted a management style that attempts to track the appropriate market index in an attempt to avoid having clients move their money to a less expensive index fund. Unfortunately, many investors  are not aware that they are investing in these so-called “closet index” mutual funds, generally receiving index returns at a cost four to five times higher than an index fund.

Even more troubling is the fact that the stated expense ratio on closet index funds may not reflect the effective cost for investors. Closet index mutual funds are often described as mutual funds that have a high R-squared rating, a statistical measure. While there is no set R-squared rating that designates a mutual funds as a closet index fund, most people would agree that an R-squared rating of 90 or above suggests closet index fund status. Some use an R-squared rating  as low as 80 as the closet index fund threshold.

Morningstar states that R-squared “reflects the percentage of a fund’s movements that are explained by movements in its benchmark index, [as opposed to any contribution by active management.]  An R-squared of 100 means that all movements of a fund are completely explained by movements in the index.”

An R-squared rating of 98 would indicate that 98 percent of an actively managed mutual fund’s movement could be attributed to a market index, with only 2 percent of the fund’s movement being explained by active management. If an investor is paying an annual expense fee 0f 1 percent for an actively managed mutual fund that only contributes 2 percent of the fund’s movement, and a comparable index fund is available for just 0.20 percent, the effective annual expense ratio is significantly higher than the stated 1 percent.

In fact, the effective expense ratio for closet  index funds is often four to five times higher than the fund’s stated annual expense, sometimes even higher. Professor Ross Miller created a metric, the Active Expense Ratio (AER), to calculate the effective annual ratio on closet index funds. In our example, the Active Expense Ratio would be approximately 5.60 percent, not the fund’s stated ratio of 1 percent.

In essence, the higher a fund’s R-squared rating, the greater the deviation between its stated annual expense ratio and its AER.  Each additional 1 percent of fees and expenses reduces an investor’s end return by approximately 17 percent over a twenty year period. Given the fact that financial advisors rarely disclose the R-squared rating or the issue of closet index funds when they make investment recommendations, investors might want to check a fund’s R-squared rating on Morningstar before they make their final investment decisions.

To learn more about James Watkins, visit him www.investsense.com.

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