Watch Out for Closet Index Funds

The tremendous growth of low-cost passive funds and ETFs has made the practice of active fund managers not earning their fee by closet indexing even less acceptable for investors

Mathieu Caquineau, CFA 11 March, 2016 | 10:14AM
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'Closet indexing' is the common term used to describe funds that claim to be actively managed but in fact are not sufficiently differentiated from the benchmark to support that claim. There are a few ways to spot funds that mimic their benchmark. Tools such R-squared and tracking error describe a portfolio's deviation from the benchmark index in statistical terms based on its past returns. By directly comparing and measuring differences between a fund's portfolio holdings with its benchmark holdings, the concept of active share has offered investors a new tool to quantify the activeness of a fund and therefore identify benchmark huggers.

20% of European large-cap funds could be labelled as closet indexers

The concept was popularised in a working paper by the then-academics Martijn Cremers and Antti Petjistö in 2006. Cremers & Petajisto drew the line between ‘active’ and ‘closet-indexing’ funds at an active share of 60%. It should be noted that while this threshold has effectively become an industry standard, the limit is valid only as long as the underlying benchmark index is well diversified.

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About Author

Mathieu Caquineau, CFA

Mathieu Caquineau, CFA  Senior Fund Analyst, Morningstar France