Closet Indexing

This refers to the process of discretely (i.e. without publicity) imitating the market index, in order to achieve nearly similar results. A fund manager practicing closet indexing would think along those lines: I don't care if Nortel is outrageously over-valued or not. Since it carries a 4% weight in the S&P/TSX Composite Index, I should buy a large position in it for protection. If it keeps going up, I'll report above average results. If it goes down, I'll suffer like everybody else. Either case, I'll not be judged severely".

Knowing that they are measured against a market benchmark (like the  S&P/TSX Composite), many fund managers are tempted by closet indexing because it allows them to report results similar to that benchmark's . They keep similar holdings as the index, albeit with slight variations in order not to abandon any hope of beating it.

What is wrong with closet indexing if it gets me above average results?

If what you're looking for is simply above average returns, a closet indexer will achieve that for you. But closet indexing is not a fair practice because it makes you pay for something you don't get, i.e. active portfolio management. If your objective is to imitate the index, you might as well invest in an index fund. It is better and cheaper than an actively managed fund that practices closet indexing.

Are there any advantages at all to investing in a closet indexer?

Actually, yes. Although they emulate the index in bull markets, closet indexers have some flexibility to increase cash levels in bear markets or to selectively dump certain undesirable securities. They are not bound by the same rigid rules as index fund managers. As a result, closet indexers depict superior down market performance (i.e. low risk) and low trading costs compared to index funds. For that reason, closet indexers with low management expense ratios often depict better risk-adjusted returns than index funds.

How do I know if my fund engages in closet indexing?

There are several indicators that you can review:

1- Size: when funds become very large, they find it increasingly difficult to identify good investments. What is the safest way to employ the heavy cash received every month? By putting it in companies well represented in the index (i.e. Nortel, BCE, banks, etc.).

2-Portfolio composition: look at the sector representation in the portfolio as well as the fund's top holdings. If those are similar to that of the index, you should immediately suspect the presence of closet indexing.

3-R-Squared: an R-Squared of 95% or more means, in statistical terms, that 95% or more of the fund's results are explained by similar movements in the index.  To check your fund's R-Squared, follow the link to the FundScope Snapshots or, to find the fund's with the highest (or lowest) R-Squared in each category, follow this link.