What Are Closet Index Funds And Why Should You Avoid Them?

While mutual fund investments can be exciting, the variety of products available in the mutual fund market can be overwhelming at times. As far as a fund manager’s involvement is concerned, there are essentially two types of funds:

  1. Actively managed funds
  2. Passively managed funds

Actively managed funds are equity funds where the fund manager actively monitors the stock market movement and pushes around investments regularly in an attempt to deliver high growth to the investors in the shortest time possible. Here, simply because of the effort and expertise it takes to make the funds profitable as well as deliver above-market returns for investors, the cost for the investor is higher than other types of funds. The expense ratio, which defines the percentage of investment it takes to manage and administer the fund, gives a rough idea of the cost of the fund.

Passively managed funds, as the name suggests, are funds where the fund manager does not need to be on his or her feet, tracking the market or moving investments regularly. This means that the return on investment is generally slower and your wealth increases over a longer duration of the investment. The expense ratio, and therefore, the overall cost of investment, is generally lesser in passive funds than in active funds. A perfect example of a passive fund is an index fund.

What are index funds?

Index funds are specialized equity mutual funds that track a benchmark index, like the FTSE or the S&P 500. The main difference between index funds and other equity funds is that the objective of index funds is to deliver returns at par with the index being tracked, and not attempt to surpass index returns like other equity funds do. Index funds are traditionally low-cost funds because the composition of the funds simply ape the chosen index and are passively managed funds. The expense ratio is one of the lowest in the industry.

Financial institutions and financial advisors are often quick to promote actively managed mutual funds as a guarantee for a financially secure future and returns that beat the market, consistently. Yet time and again it has been observed that these actively managed funds have been underperforming the market, i.e., delivering returns that are lesser than the market returns, over a long period.

In fact, according to a recent S&P study (2020), a staggering 82% of US equity funds with active fund managers have failed to beat their S&P 500 benchmarks in the past 10 years! The 15-years performance is even more dismal. Regardless of a bull or bear market, this underperformance seems to continue, the report said.

In contrast, there is no such pressure in index funds simply because the goal of the fund stated upfront is that it will return whatever the benchmark does. The fund manager simply picks the same composition of the index in the same weightage and then may sit back and watch the fund perform at par. There is a marginal variance that occurs in returns called tracking error, which is the only variable that the fund manager needs to monitor occasionally and attempts to keep at the minimum.

It therefore shouldn’t come as a surprise that investors are finding favor in passive funds, and are moving away from actively managed funds in large numbers. After all, meeting market returns is logically better than underperforming the market! This influx spells trouble for active funds.  Actively managed funds have gotten so big (in size of fund) that fund managers have no option but to track the market benchmarks.

As a workaround, many fund managers have created mutual fund schemes which in reality only replicate the index, but they pass them off as actively managed equity funds. Two motives are achieved here: a) The fund manager is not hard-pressed to move money around within the stock composition of the fund since the results are likely to be at par with market returns, and b) the higher expense ratio (what the fund charges customers as management fees) of the active equity fund is maintained.

The expenses on these funds are displayed four to five times higher than actual index funds. We shall attempt to outline ways in which you can identify whether or not your actively managed fund is just an expensive alternative to an index fund.

What are closet index funds?

Closet index funds refer to the actively managed funds which just shadow an index. Considering its nature of being an actively managed fund, higher charges are levied – such as a higher expense ratio, professional charges, and so on. But in reality, these funds just clone an index fund.

The latest SPIVA scorecard – a comparative study of the performance of mutual funds with the benchmark index S&P 500 – released by S&P annually, has some interesting insights. It provides evidence for the trend that over the last 20 years, only 4% of large-cap mutual funds, 10% of mid-cap mutual funds, and 6% of small-cap growth funds (actively managed equity funds) were able to outperform their benchmarks.

The cost of investing in closet index funds

The second issue here is that retail investors are often not aware of the fact that they are investing in closet index funds and are incurring 4-5 times the cost for the returns provided by any index fund. The average annual expense ratio for index funds usually hovers around 0.17% of the investment amount whereas the average expense ratio for actively managed funds is around 0.75%. The expense ratio for some funds is even as high as 1.5% of portfolio investment in the fund.

How does the expense ratio matter to investors?

The expense ratio is a percentage of the investment amount that is adjusted against the NAV of the fund when calculating your returns from the fund. This means, the less the expense ratio of a fund, the more likely it is that the returns you earn from the fund are higher.

Did you know that it is estimated that every additional 1% in fees and expenses charged by an actively managed fund reduces roughly 17% of returns over twenty years? It becomes clear and even more important now to recognize if your actively managed fund is just a closet index fund, robbing you of your future returns. What is even more troubling to note is that the expense ratios stated on the “closet” index funds may not even be reflective of the true cost of managing the fund.

How to identify if your fund is a ‘closet’ index fund

We’ve established the importance of identifying whether the actively managed fund your advisor is pushing to you is just replicating an index fund. Using the combination of the below-mentioned metrics, one can decipher whether or not that is the case:

  • R-Squared: R-Squared is an extremely important statistical measure that helps compare the movement of a given fund to the benchmark index, expressed as a percentage. The higher the R-Squared value, the higher is the correlation between the given fund and the benchmark fund – i.e, the majority of the movement in the fund is as a result of the stock market itself moving.

This translates to the revelation of a level of duplication between the actively managed fund and the index benchmark. An R-Squared value of 100 indicates that the performance of the fund entirely tracks the benchmark index fund, and all movements in the fund are a result of movement in the index. An R-Squared value of 95 would indicate that 95% of a so-called “actively” managed fund’s movement can be explained by the movement in the benchmark and only the remaining 5% of the fund’s movement can be attributed to actual active management by the fund manager.

Generally, R-Squared values are divided into the following tiers:

1-40%: Low replication of the fund in comparison to the benchmark

41-70%: Average level of replication in the fund when compared to the benchmark

71-100%: High level of replication in the fund when compared to the benchmark; therefore, most likely an index fund.

Even though there is no threshold of R-Squared value that classifies an actively managed fund as a “closet” index fund, it is advisable that if your actively managed fund shows an R-Squared value of 85% or above, you would be much better off buying an index fund rather than an actively managed fund that mirrors the benchmark and charges you significantly higher for doing so.

  • Tracking error: Tracking error refers to the difference observed between a fund’s performance and the performance of the benchmark it is being compared with. This metric is also expressed as a percentage. A low tracking error would indicate that the fund is duplicating the index. Even passively managed funds that are perfectly indexed against a benchmark exhibit some tracking error because even they don’t match the benchmark perfectly. However, over the years, the tracking error is likely to be minuscule. 
  • Active share: Active share refers to the percentage of holding in the fund that differs from the benchmark index. The higher the active share percentage, the higher the chance that the fund manager is trying to actively beat the benchmark using his/her skills with stock picking. On the contrary, a fund with no active share percentage essentially means that the holdings of this fund are the exact replication of the benchmark. Funds with high active shares tend to outperform their benchmark indices, and hence command a higher level of expense ratios and fees.

Even though R-Squared, Tracking error and Active share are all good indicators of whether or not a fund mirrors the benchmark, they do not guarantee the future performance of the fund. If an investor is looking for an actively managed fund to beat the benchmark returns, he/she could look for funds with a  low expense ratio and overall fees to reign in the outflows from the profits.

To conclude

Closet index funds just shadow a market benchmark providing similar returns while having expense ratios that are 4-5 times higher than the benchmark costs.

It is imperative to recognize when a “closet” index fund is masking itself as an actively managed fund to save on the hefty costs associated with actively managed funds. To do so, three metrics play an extremely crucial role: R-Squared, tracking error, and the number of active shares.

It is important to note that even if a fund performs well on the above-mentioned metrics and qualifies as not a “closet” fund, that is no guarantee of future performance. Market risks, risk appetite, diversification of the portfolio, expense ratios of the fund, and asset allocation are some of the factors that must be taken into consideration before investing in any mutual fund.

For help in identifying the best mutual fund for your risk profile, or to help you with complete investment planning and execution, get in touch with qualified financial advisors here. Use our free matching tool on Paladin Registry to connect with 1-3 background-verified financial fiduciaries.

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