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
Company X is outrageously over-valued. Since it carries a 4% weight in the 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
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
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 often depict superior down market performance (i.e. low risk) 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:
- 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.
- 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.
R-Squared of 90% or more means, in statistical terms, that 90% 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.