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 November 2006 Closet Measurements An Ill-Founded Attempt to Assess Closet Indexing
This wasn't an issue until the 1990s when mutual funds became the investment of choice and stocks of the S&P 500 led the charge. At one point in the late 1990s, the top 50 stocks of the index accounted for 100% of its return. Any fund manager who didn't focus on those 50 stocks failed to keep up with the benchmark. As a result, a growing number of funds held the same stocks. Many simply followed the index as a means of keeping up. Managers who fell behind -- many due to poor stock selection -- charged their more successful competitors with "closet indexing". In other words, those focusing on stocks in the S&P 500 were merely disguised index funds charging fees for (nonexistent) active management. Their investors were paying something for nothing. It's been almost a decade since the heyday of closet indexing yet if anything, the label "closet indexer" is more derogatory now than it was then. As the debate between active and passive management continues, no one wants to be cast as a closet indexer. Oddly enough, until recently, the term was never clearly defined or quantified.
Closet Inventory The critical measure was a fund's "active share" which was defined as the percentage of the fund's holdings that didn't exactly overlap those of the index. For example, if a particular stock comprised 6% of the index, a fund with an 8% weighting had a 2% active share while one that mirrored the index's 6% weighting or fell below it had a 0% active share.
Funds that had overall active shares of 20% to 60% were potential closet indexers. The study found that although the average expense ratio of closet index funds was lower than that of more actively managed funds in their categories, it wasn't substantially lower. In other words, investors in closet index funds were paying active management fees for passive management. The study also found that returns tended to be higher for funds with higher active share. Mr. Petajisto credited this to the fact that more actively managed funds tended to have more highly skilled managers. All in all, that's a pretty bleak assessment of all those closet index funds out there: Lower returns and higher fees for funds that underperform. Why is the Index Off Limits? At this point we should disclose the fact that we were unable to secure a copy of Messrs. Petajisto's and Cremers' study. All we have came from The Wall Street Journal so we certainly don't have each and every detail. Nevertheless, the study does raise issues that are frequently debated and are worth addressing. At it's most fundamental level, the concept of "closet indexing" is in need of a clear definition. Basing it on the quantitative notion of "active share" is an intriguing attempt, but it will only be successful if this definition truly captures "closet indexing". Intuitively, a "closet index" fund should be one that looks like or at least has the characteristics of the benchmark index. In order to capture this using the concept of "active share", a fund that exactly mirrors the index should have a low or even non-existent active share value, and indeed it does. But what about a fund that held those 50 stocks that led the market in the late 1990s? Was it a closet index fund? Because each of the 50 stocks was such a large portion of the overall S&P 500, such a fund would not have scored highly in a test for active share. But do you agree that this 50-stock portfolio is really a closet index fund?
Arguably, a fund that only holds 10% of the stocks in the benchmark shouldn't be viewed as an index fund. Indeed, funds with high active share might have actually held more of the stocks in the index, just in lower proportions. If a manager is making the conscious decision to hold 50 stocks while shunning 450 or more, one could plausibly argue this is just as much an active decision as the choice to find stocks outside the index. Which brings up the second point: Active share is based on the difference between actual fund holdings and overlap with the index. If a stock has a 6% weighting in the index but a funds holds 8%, it gets credit for 2% active share. But if the fund holds only 3% rather than the index weight of 5% it gets no active share credit. Why doesn't it? Shouldn't the managers decision to underweight the stock by 3% relative to the benchmark get the same credit as the decision to overweight it relative to the index? If you agree, then you should also believe the manager of that 50-stock portfolio should also be given credit for the decision not to utilize the other 450 stocks in the S&P 500. Under this scenario, the fund would move from being a closet index to being one with a high active share. Going to Extremes Applying this to the earlier example, the most highly rated actively managed fund compared to the S&P 500 wouldn't hold a single stock from the index. What would that look like? Obviously it could be drawn from large cap stocks not included in the S&P 500, but it could just as easily be made up of small cap stocks, or foreign stocks, or even bonds. At this point you've got to wonder why the S&P 500 would be a benchmark for a fund that doesn't necessarily invest in S&P 500 stocks. This calls the whole concept of benchmarking into question but more importantly suggests there's got to be something inherently wrong with a system that gives its highest marks to a funds that are the furthest divorced from their purported benchmark.
Perhaps this is a misinterpretation of the study and if so, we apologize, but many investors do express unwarranted fears that funds with any holdings in common with their benchmark are simply closet indexers. Duck Test Closet indexing becomes more of an issue if the fund has 300 or 400 of the S&P 500 stocks; more than 400 and the fund really does start to become the index. Yet most funds actually consist of 150 stocks or less. Can they legitimately be accused of closet indexing? Common sense will tell you if a fund looks like the the index and its holdings are weighted like the index, then it's some version of an index fund. On the other hand, if the fund holds only a fraction of the stocks in the index and with different weightings, it isn't any type of index fund, closet or otherwise. You don't have to do any fancy calculations to come to this conclusion. There's no need for newfangled quantitative measures. If it looks like a duck and acts like a duck, it's a duck. If it doesn't, it isn't. It's just that simple. Search this site! Just enter you key word or words:
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O ONE WANTS TO PAY something for nothing. You always want to feel you're getting some sort of value for your money. So why would you pay fees for active management when your mutual fund or equity manager is simply mimicking the index? You could do that yourself for only a fraction of the cost.
