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Advisor Blog
Is Your Active Fund Really a Closet Indexer?
As indexing and passive portfolio management has gained in popularity and active managers have acknowledged how difficult it is for them to outperform an appropriate benchmark index net of expenses, more and more active managers are behaving like passive managers. Simply put, they are constructing portfolios that are highly diversified and correlated to their benchmark index with minimal tracking error. They look and perform much like an index fund, but with the vastly higher expenses of an actively managed fund. This, unsurprisingly, is a recipe for underperformance.
A recent study conducted by Yale professors Martijn Cremers and Antti Petajisto concluded that as few as 20% of supposedly active managers actually manage money on a truly active basis. Their opinion is that the others are not providing sufficient value for the high fees that they charge. And, of course, there is no guarantee that true active management can outperform the benchmark. But, it is almost a guarantee that "closet indexing" while charging fees consistent with active management will underperform.
How do you spot a "closet indexer"? Look at the fund's R-squared statistic. This measures the fit of a regression line between the fund's performance and the index. If it's above 0.95, the fund is tracking the index very closely. That's fine if it's designed to do so, but it may indicate a problem if you're paying a high fee for active management.
Comments
Great point, David. When you are constrained by the small number of choices available in a qualified plan, that may be a very valid way of choosing a fund. But, if you are selecting funds from the universe of available funds, you would do much better picking the actual index funds with low expense ratios.
This article was interesting to me because in the past in my 401k (which had only a S&P 500 index fund)I tried to choose funds that are most like index funds, in particular funds with low turnover, large number of holdings, and capitalization and style consistency. I figured if a fund has these things it's likely to perform similar to an index fund. I see now that the R-squared figure is an even better predictor of that.