For many, the benefits of creating a long term diversified index portfolio are well known. In fact, the emergence of ETFs that enable access to small cap international, emerging markets, commodities, foreign currency and many other hard to reach asset classes has helped passive indexers achieve more diversification and for many index professionals, higher returns.

This last year I have seen a resurgence in the Active Vs. Passive debate since the S&P 500 has a negative 10 year track record. While the defenders of passive investing on our news media outlets seem to refer to buying and holding individual securities versus actively trading securities, there is also a debate on whether to buy and hold index funds or mutual funds.  Active fund managers want you to believe that they can always time the markets’ ups and downs and that, for the most part, they will pick winning stocks. This is of course absurd, but many individual investors fall for short term out performance not thinking about long term results.

There is joke that financial news journalists write about the hot stock or mutual fund by day and privately invest in long term healthy index funds by night. Could this be true of active fund managers as well? This is where the term “closet indexer” comes from. A closet indexer is a fund manager that mimics the index, or benchmark that he or she is assigned to outperform. For example, if a fund manager has the same holdings as the S&P 500, thus the same performance, he or she would be a closet indexer. The problem here is that the investor is probably paying 50bps (0.50%) or more for the performance, thus would have been better off buying the S&P 500 ETF (SPY) or the Vanguard S&P 500 index mutual fund equivalent (VV)  with fees less than 1/10 of a percent.

Job security and fund size are two major reasons why a fund manager would mimic an assigned index. Funds managers have their performance measured quarterly and thus do not want to stray too far from their assigned index. While they may take additional risk at times to make up for their fees or try to outperform the market, the overall portfolio is invested in the same sector percentages as the index. The idea is that fund investors would pull their money out for poor performance but would probably not if the fund manager performed near the index or his or her peers.

The size of the mutual fund may also push the manager towards being a closet indexer in that only so much can be invested in companies that the managers sees as outperforming the market. The remainder of the fund’s assets are then invested in securities that match the index so that overall performance versus the index will not go array.

Closet indexers are fairly easy to spot. The most common way to find one is to take the R Squared of the fund. R Squared is a statistical measure that represents the percentage of a fund or security’s movements that can be explained by movements in a benchmark index. For example if a fund has an R Squared of 97, then 97% of its movements matched that of its assigned index such as the S&P 500.

I did a search within Morningstar’s database of 24,900 open ended mutual funds for a 10 year R Squared greater than 96, fees greater than 0.50% and got 742 funds. In most cases an ETF should not cost you more than 35bps (0.35%) thus I gave the fund managers the benefit of the doubt by searching for management fees greater than 50bps (0.50%). This means that 3% of all opened end mutual funds perform no better than their assigned index over a ten year period and cost double what they should be.

When I dropped the R Squared to 95 or greater, 1,723 funds were returned making 7% of open ended mutual funds subject to our closet indexer title. I then looked for an R Squared of 97 or greater over the last 12 months with a management fee greater than 0.50% and the return increased greatly to 5,377 funds, making 22% no better than the index itself.

As you look at your mutual fund you have to take into account the cost of active management. Maybe your manager beats the market by a few percentage points, but what kind of fees do you have to pay for this performance. Is the net performance near the index returns? Is your fund manager a closet indexer?

This New Year you should consider putting your portfolio on a diet and look at the benefits of low cost Exchange Traded Funds (ETFs). You should at least be asking the question as to why you are not using ETFs.

 

– Casey Smith is the President of Wiser Wealth Management