Thursday, March 3, 2011

The Case of the Closet Indexer

There's a mysterious character in the world of investment management and he's known as the closet indexer. The mystery surrounding this character is made maddening by the fact that while his actively managed mutual fund may indeed be highly correlated to a benchmark like the S&P 500, he's likely to trail the return of the index after fees and expenses.

Unfortunately, many actively managed funds are now "closet indexing". You may wonder why I am so against this practice when I'm such a strong advocate of index funds but the answer is simple: not only do you get hit with larger fees and expenses for investing in the actively managed fund, you're likely to experience under-performance in certain markets because the funds are still actively managed and may be more conservative or aggressive to capture some upside in falling or rising markets. This is a recipe for disaster because it's not likely that the manager will be perfect all of the time, further hampering returns.

Martijn Cremers, a finance professor at the Yale School of Management points out that the main rationale for this practice is that individual investors are more "benchmark aware" and they are quick to sell funds who underperform a given benchmark. After reading this, it sounds like they just don't know about the virtues of actual index funds!

The Smart Money article linked above highlights the main issue: "of the 514 actively managed funds in Morningstar's large-cap blend category, 79 mimic the index almost exactly . And that means they're almost guaranteed to underperform, because 'you'll get the market return – less the fees,' Shannon Zimmerman, the associate director of fund analysis at Morningstar."

I was more shocked by this quote from the manager of an actively managed fund that the article dubbed a "closet indexer": "Scott Glasser, co-manager of the Legg Mason Clearbridge Appreciation Fund, says that while his fund has been highly correlated to the S&P -- and charges an expense ratio of 1.05% -- it is more conservative than the index and has outperformed its benchmark over the past three-, five- and ten-year periods. 'This fund may have higher fees, but it's earned those fees over time,"

I'm really not too sure how the fund "earned" its higher fees over the long-term and it begs the question - why settle for mediocre performance that's made worse by excess expenses when you can just buy an index fund and be done with it? The article mentions that the Vanguard 500 Index Fund (VFINX) has a 0.18% expense ratio while the SPDR S&P 500 Index ETF (SPY) has a paltry 0.09% expense ratio. To me, the choice is clear: stick with the real index fund and avoid closet indexers.


  1. Hey Tim,
    This is a really interesting blog you've got here. I've just recently found out about the book that you've written, and I'll make sure I hunt it down when the libraries re-open. I'm in Christchurch, down in New Zealand, and we've had some pretty severe earthquakes, which have put a bit of a damper on my investment research, but I'm hoping to open a forex account soon and have a test run.
    From what I've read so far, your story is absolutely amazing, and I really hope that me being 15 doesn't mean that I'm too far behind.
    Keep up the posts! I certainly appreciate them.

  2. Hi Logan, sorry I'm seeing your post so late. I hope you're doing well and that you weren't impacted by the terrible earthquakes that made their way through New Zealand.

    I wish you the best of luck in your investments. It really is simple to figure out once you start reading and doing research (as you know). At 15 years old, you've certainly got an amazing head start. Please do not hesitate to email me if you have any questions and I hope you enjoy "The Teenage Investor"