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Closet Index Funds: What They Are and Why to Avoid Them

Hiding something?

Hiding something?

Closet index funds are actively managed funds that claim to attempt to beat the market, but in reality they simply mimic an index fund (at a higher cost).

The problem, of course, is that if a fund manager is investing in the same stocks that make up the index (and in similar proportions), while at the same time charging you higher costs, then there’s roughly zero likelihood that the manager will actually succeed at his job. (His job being to outperform the relevant index/benchmark.)

How to Spot a Closet Index Fund

One way to determine whether an actively managed fund is a closet index fund is to calculate the correlation between the fund’s performance and the performance of its relevant index/benchmark. The higher the correlation, the more likely it is that the fund manager is a closet indexer.

As a random example, I went to Fidelity’s fund overview page, and chose the first domestic stock fund in the “Large Blend” category that has been in existence for 10 years or more: Fidelity Disciplined Equity Fund. (I used a Large Blend fund simply for convenience, as that’s the category for which the S&P 500 is the relevant benchmark.) Then I dropped the fund’s performance figures into a spreadsheet along with those of Vanguard’s S&P 500 index fund:

Picture 3

Next, I used Excel’s “correl” function to calculate the correlation between the two. The answer? 98.7% correlation. Hmm…think we caught one?

Check your own funds.

If you invest in any actively managed funds (or are considering doing so), you might want to try the above exercise on them. It could be an eye opener. Be sure, however, to use the appropriate index. (For example, don’t compare an international stock fund to the S&P 500.)

Of course, I’d still argue in favor of avoiding actively managed funds entirely, if that’s an option.

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Comments

  1. Also, beware of closet index portfolios. Brokers love to sell multiple mutual funds that focus on different strategies in the name of diversification. While the individual funds may bear less of a resemblance to the overall market, when mixed together, they often will become an accurate sample of entire markets. In doing this, you’ll be paying extra fees to different mutual fund managers to bet against each other, canceling out even the lucky guesses. It’s like paying to bet on red and black at the same time at the roulette table, a losing proposition to everyone but the fee collector. Some brokers even add an extra layer of fees for such a “service.”

  2. This blog entry explains (in my eyes) why most active funds are not worth investing in. I believe that those on the look-out for really good funds might be able to find a few. But the phenomenon described here shows that marketing considerations are often dominant when funds are constructed. They’re using the index to get good performance and then packaging it as a non-index fund to justify higher fees!

    A big plus of indexing is that it is so simple that the average person can understand what is going on and thus can better protect himself or herself from the marketing mumbo-jumbo.

    Rob

  3. When you don’t have access to a real index fund, say in a 401k plan, using a closet index fund is not bad because you know it will stay close to the index. It is least likely to do crazy things.

  4. Most of the actively managed funds have such a high correlation. Economists would call this an agency problem. Fund managers really don’t have much incentive to stick out by deviating too much from the benchmark index. The reward for excelling is not big enough. On the other hand the punishment for underperforming significantly is very bad – the fund manager gets fired and has to live with a poor performance record, which will make it difficult to get a job again.

  5. TFB: You raise a good point there. Thanks for bringing that up. 🙂

  6. pkora94 says:

    Is it just my maths but the actively mannaged fund seems to have beaten the passive fund by 15% over that period of time.

  7. pkora94, yes, that fund outperformed by roughly 1% per year over the last 10 years. Would you bet on that happening again?

  8. pkora94 says:

    If the next 9 years turn out to be exactly the same as the previous then i am willing to take that bet otherwise i think i will take a bet on something else.

  9. That’s the whole point though: We don’t know what the next 9 years will look like. We have to choose what to do with our money without that knowledge.

  10. I was trying to do this with active fund that I own (RPBAX) a balanced fund under T Rowe Price. What would be the benchmark for that? I see that the prospectus compares it to the Lipper Balanced Funds Index and Merrill Lynch Capital Market Index as well.
    Or am I going in the wrong direction?

  11. Damilola: I’m not familiar with the second index you mentioned. The Lipper Balanced Funds Index could be a useful comparison.

    Alternatively, you could determine how highly the fund’s performance is correlated to a blended portfolio of, say, the S&P 500 and the Barclays Capital Aggregate Bond Index.

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