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”It is easier to fool people than to convince people that they have been fooled.” –Mark Twain

17.10.2013Being in a closet will be costly for a fund investorErnst Grönblom

Closet-index funds and the problems related to them have received only little publicity, although they are very problematic for fund investors.

One natural reason for the lack of attention is the fact that the subject is abstract and unknown to several investors. Still, one doesn’t have to be a conspiracy theorist to understand that the financial industry intentionally keeps attention away from the subject instead of pointing it out, because it is one of the most efficient profit generators in the investing industry.

What are the so-called closet-index funds? They are funds, mostly equity funds, that are marketed and priced as actively managed funds, but in reality, based on their structure and strategy, are in fact passive funds. An alternative name for these funds would be a quasi-active fund.

(Notice, this blog text assumes that the reader has at least a basic understanding of the discussion around market efficiency and the division of investment strategies to active (i.e. funds that take strong views) and passive (i.e. funds that mechanically follow the markets, such as index funds and ETF products). To be clear, the term “active”, when used in the context of investing strategy– contrary to colloquial language – doesn’t refer to constant buying and selling, but taking a clear stance (a view) in the portfolio’s, which could be contrary to the consensus.)

A typical example is a fund, which is advertised as an active fund, but in reality has a portfolio that replicates the market based on its composition and weights (i.e. the fund’s benchmark index) and therefore in reality it is almost impossible for the fund to provide “alpha” (i.e. excess return over market return). This is due to the simple fact that in order to a fund to have even a theoretical possibility to beat its benchmark index, the fund needs to differ from the index to a certain degree. A fund that closely replicates its benchmark index inevitably will closely emulate the index’s returns as well.

The drawbacks of closet-indexing

The most important thing for a portfolio manager managing an active fund is to have a strong view. A closet-index fund manager doesn’t have to have clear opinions, because he can just follow the benchmark index like sheep follow the herd. The problem might not sound so serious to a layperson, but closet-indexing leads to ethical and financial contradictions. The most significant ethical issue arising from closet-indexing is the misleading marketing related to the funds. The customer is promised to receive active management and is charged as if the portfolio is actively managed, when in fact the customer gets passive portfolio management. The financial drawbacks of closet-indexing come from the lost profits and from the fees charged based on active management. Closet-indexing combines the worst sides of passive and active portfolio management; the high fees of active management and the returns of passive management, which tightly follow market returns. The above reasons are why closet-index funds always lose to their benchmark indices in the long run, especially when management fees are taken into account when calculating total returns.

One of the most important goal of active strategies, if no the most important, is to produce alpha, meaning to overperform the market. Because of the structure of closet-index funds they can’t achieve this goal and we can say without exaggerating that closet-index funds don’t have any real justification for their existence (from the client’s perspective that is).

Characteristics of closet-index funds

There doesn’t exist a precise and objective definition of a closet-index fund, but they have a few relatively easily identifiable characteristics.

One useful tool to identify a closet-index fun is Active Share – tool, which calculates how much a fund differs from its benchmark index. If a portfolio’s Active Share is 40%, the rest 60% of the portfolio emulates the benchmark index. Finnish-born Antti Petäjistö, who has for example been an Assistant Professor of Finance at NYU Stern School of Business, has developed this tool.

Identifying a closet-index fund always requires a full analysis of the fund and the following questions should be considered in the analysis:

– What is the portfolio’s Active Share? According to Petäjistö, a score between 20 and 60 strongly indicates that the fund is a closet-index fund. (Funds with scores below 20 are often actual index funds.)

– Is the fund compared to the correct benchmark index? If the benchmark index is too “comprehensive” related to the funds composition (for example the global MSCI World index, when it should be the Finnish OMX H25) the fund’s Active Share is misleadingly good.

– How many positions does the fund have? Is active portfolio management in general even sensible with the fund’s diversification?

– What is the fund’s turnover ratio? Because every company dropped out of the fund must be replaced by a new company, a high turnover takes too much of the portfolio manager’s time, which should be used to analyzing individual positions.

A simple way to quickly identify a closet-index fund is over-diversification. Both, the fund and the fund management are tampered when the portfolio is overly diversified. When a single position is insignificantly small, even a successful investment decision cannot move the rest of the portfolio up. Even portfolio managers are mortal and their resources, especially in this case efficient use of time, are limited. If the portfolio has tens or even hundreds of different companies, the portfolio manager can’t allocate more than a few hours a year to analyze each company. It is highly unlikely that this would be sufficient to generate information edge, which is the key for successful active management.

What is the maximum number of companies a single portfolio manager can follow efficiently? The question can only be answered by giving subjective opinions. Those readers who have personal practical experience from working in a large corporation, can probably concur with me when I say that a single person cannot fully be aware of everything that is going on even in a single company. Based on my personal experience, intuition and simple calculations, I would say that a portfolio manager who has more than 30 to 40 companies in a portfolio has too much on his plate.

How common is the problem?

Statistics about closet-indexing are best found from the U.S. markets. As a rule of thumb, we can say that currently 20% of the total funds invested in equity funds are in passively managed funds, approximately 50% are in actively managed funds and the rest 30% are in funds that meet the criteria for closet-index funds. The situation is changing constantly, but unfortunately closet-index funds seem to be gaining more ground. There is very little information about European markets, and basically none from Finland, but it would be naïve to believe that the situation would be better in Europe. We can assume that concerning the relative fragmentation, lower stage of development and other similar issues of the European markets, the problem is most likely even worse than in the U.S.

How much value do closet-index funds bring?

What do closet-index funds cost to investors and the economy in the form of lost returns and excess fees? Let’s assume the following:

– market return, meaning the long-term average expected return of the stock market is 5.5% annually (this number might sound pessimistic for many, but it is pretty close to experts’ consensus).

– the average total expense ratio per annum of passive funds is 0.5%

– the average total expense ratio per annum of active funds (including truly active and closet-index funds) is 1.5%

The long-term return of both passive and active funds is the market return minus expenses. Because the average expenses of closet-index funds are 1% higher than those of passive funds, investors pay an excess fee. In other words, the expected return of a passive fund is 5.0% per annum (= 5.5 – 0.5), when the expected return of a closet-index fund is only 4.0% per annum (= 5.5 – 1.5). A one percentage point difference might not seem significant, but it means that the closet-index fund investor loses one fifth of his returns. Time will amplify the difference thanks to compounding interest. If two investors both invest 100,000 euros, the other to a real index fund and the other one to a closet-index fund, in ten years the former will have 163,000 euros and the latter 148,000 euros.

When inflation is taken into account, the numbers are even uglier. Let’s assume that inflation in the future is on average 2% per annum (close to the historical average). This means that the inflation adjusted return of the passive strategy, in other words, the real return is 3.0% per annum (=5.5 – 0.5 – 2), when the real return of the closet-index fund is only 2.0% per annum (=5.5 – 1.5- 2). The closet-index fund investor loses one third of the inflation adjusted returns, for no reason.

Finnish equity funds have currently approximately 25 billion euros invested in them. If we assume that 30% of investors’ money (7.5 billion euros) is invested in closet-index funds, Finnish fund investors lose on average 75 million euros (=1% x 7.5bn) annually by investing their money in expensive and poorly managed closet-index funds, instead of investing in passively managed funds.

Why are closet-index funds sold and bought?

At this point, a conscious reader asks why would anyone provide, sell or buy closet-index funds?

There are at least two answers to the question why they are sold; (1) they are easy to sell and they are financially profitable to sell to unsuspecting customers, and (2) closet-index funds minimize the portfolio manager’s so-called career risk. Both, customers and employers are willing to forgive that a fund underperforms its benchmark index year after year, as long as the difference doesn’t get too big (which is probably the most important indicator of closet-indexing), when on the other hand an active portfolio manager who has produced alpha (excess returns) for years by having strong views and taking strong positions, will easily be fired even after a single poor year. This disparity creates a distorted incentive for portfolio managers who are concerned about their careers, to stay close to the benchmark index, in other words, to create closet-index funds. This is true, even though the job of an active manager is to have strong views. The before mentioned irrational behavior is partly explained by asymmetric risk aversion, meaning that an equal size loss hurts a lot more than an equal size profit brings satisfaction.

Why does anybody buy them? A complete unawareness of the entire problem is surely one of the reasons, but there can be other, more complex reasons cumulating from psychologically faulty thinking. People famously want to “have their cake and eat it too”, meaning people want to benefit from something, without being willing to pay the full price of it.

We can imagine that many investors are debating between passive and active investing; passive feels safe but boring (the return can never be higher than the market return) and active feels exciting but dangerous (“what if the portfolio manager fails?”).

In front of the above mentioned dilemma, one can easily prone to make a “safe bet” and to “compromise” by picking a fund which is active but not “too active”, in the hope of combining the best parts of active and passive investing. In reality – as mentioned before – the opposite is true and the investor combines the worst parts; mediocre returns and high fees. This is the complete opposite of a “Win-Win” – situation.


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