In Defense of Closet Indexers

The Unloved Last week, the Financial Times whacked closet-index funds--actively managed funds that hold portfolios that look suspiciously like stock indexes. The FT's article was sparked by an academic paper titled, "Indexing and Active Fund Management: International Evidence," which examined global fund markets. The paper found that closet-index funds were "prevalent" in all major fund markets.

The FT headlined that observation as representing a “gigantic mis-selling phenomenon.” A London Business school professor stated that closet indexing “is the active fund management’s dirty little secret. In some countries, where investors are more trusting and less questioning, the secret is well kept.” The chief executive of the Swedish Shareholders Association went further, calling on regulators to ban closet index funds that have annual expense ratios of more than 0.8%.

There were no defenders of the practice. There never are. Nobody puts in a good word for closet-index mutual funds. Until today.

Critics decry closet-index funds because they believe such funds are doomed to trail. By restricting their investment opportunities, closet-index funds cannot make enough money from their active decisions to overcome their expense handicap. In the words of the Swedish shareholder advocate, “the likelihood of these funds outperforming low-cost index funds is less than microscopic.”

The critics also believe that closet-index funds are deceptive. They claim to be active, but in reality are mostly passive. They sell a commodity product that is misleadingly packaged.

The Good, the Bad, and the Lucky Let's review the standard academic beliefs about active investment management--

1) The financial markets, for the most part, are ruthlessly efficient.

2) Thus, when active managers beat (or trail) indexes, that result owes mostly to chance.

3) There are some investment managers who beat the indexes through skill.

4) Unfortunately, those skilled managers are few in number.

5) Also unfortunately, the few managers who possess skill look very much like the many managers who possess luck.

It’s easy to see how those views support the case for index funds. If the two flavors of successful active managers cannot be readily distinguished, then most winning active funds will disappoint. Their luck will fade, leading them to match the indexes before expenses and to trail after expenses. Better instead to buy an almost-costless index fund, which has a higher expected return than the actively run funds because of lower ongoing costs.

That is a very familiar story, and correct insofar as it goes. (How far it goes depends on the investor’s ability to separate the intelligent sheep from the fortunate goats.)

The question is, how do we get from there to the notion that closet-index funds are the guiltiest of the active-management breed?

One way is to claim that the more active the manager, the better the fund. The academic paper, co-authored by one of Active Share’s inventors, takes that road, asserting that every incremental increase in a fund’s Active Share score boosts its expected returns by an annual percentage point. By this argument, cautious funds like closet indexers are the worst funds.

That is possible. It's a thorough paper, and I have not worked through the data tables enough to question the argument. However, it should be noted that Fidelity, AQR Management, and Morningstar's Russel Kinnel each dispute previous claims of a correlation between Active Share scores and fund performances. Those three parties are sympathetic to active management and would like Active Share to be predictive. They just did not find it to be so.

History's Tale Mutual fund history also does not seem to support the proposition. Concentrated funds sprung up the '90s with the promise that, by investing with conviction by holding relatively few securities (and therefore generally achieving high Active Share scores), they would outdo conventional funds. They have not. If stronger performance comes with higher activity, one would have expected concentrated funds to have swept the industry. Instead, they are relics of history.

Conversely, closet-index funds have demonstrated that their odds of beating actual index funds over long time periods is far more than microscopic. As I write this, four of American Funds’ seven U.S. stock funds have bested the S&P 500 over the trailing 10 years, and all seven are ahead of the index for 15 years. Among the list of long-term stock-fund winners--that is, the select group of funds that have beaten the market indexes for 15 years or more--there’s no pattern of extra activity. Some are closet indexers, some are moderately active, and a few are highly active. As with the fund industry overall.

The results did not surprise me; I did not expect to see a relationship between the odds of beating an index and manager activity. If a manager has skill, then the manager has skill. Restricting the manager's range of motion will limit the extent to which that skill can be used but rarely so much that the fund cannot overcome its expense hurdle. Being correct on six stock selections out of 10 with only 30% of the portfolio (the rest being quietly indexed) can easily be worth 2 percentage points per year.

To which it will be objected that the manager could have doubled that relative profit had his reins been loosened. Yes, that is so. However, the same holds true for the lucky managers. Their modest gains would become larger gains if they were permitted more freedom--but that does not make their funds superior future purchases. In fact, it makes their funds worse, because the expected returns for the more active funds is the same as for the closet-indexers (the market minus expenses), but the risk of higher relative loss is greater. As the marketers of concentrated funds learned, that is not an attractive proposition.

In short, closet-index funds seem as likely as other actively managed stock funds to beat the indexes. While their victory margins in those instances are disappointing low, it must also be conceded that their shortfalls, when unsuccessful, are gratifyingly small. As a group, closet-index funds will almost surely trail the indexes. There will be individual successes, many due to fortune and a few due to ability. But those successes will be offset by the failures so that, overall, the group figures to act like the index but at a higher cost.

That same statement holds true for all varieties of actively managed fund. The attack on closet-index funds as being unlikely to beat an index individually, and just about certainly to lag as a group, applies equally to other actively managed funds. There's no reason to single out closet-index funds and spare the others.

As for the argument that closet-index funds deceive, come on now. Every active fund manager claims to have enough skill to beat an index. The more active the manager, the greater that claim. Yet in reality, few managers possess the ability. So they get off the hook, while closet-index funds are called out for being dishonest?

Pshaw. Support active management, distrust it, whatever. There are many possible, defensible views about active management overall. But not, I think, many about the merits of closet indexing versus other forms of active management. What applies to one applies to all.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.