VIEWPOINT: Closet Indexing

The fifth video in our Proteus Viewpoint video series, Closet Indexing: Are You Paying Too Much for your Money Manager?

For further information, read the below Q&A.

What is something you should consider when deciding to hire an investment manager?

When deciding to hire an investment manager, where the asset class has a clearly defined and investable benchmark, you have the choice to hire someone who passively or actively invests in the asset class. Each side has its benefits and drawbacks.

What is something you wouldn’t look for in an asset manager?

You wouldn’t tend to look for hefty fees for empty promises.

What are the pros and cons of active and passive investing?

Passive investing requires less input and decision making from the manager and therefore has a lower fee than active investing. Basically, the fund buys the stocks that are included in the index in the same weighting – you get what the benchmark gives you. On the other hand, active investing can be nimbler because active managers make the decisions of what stocks to buy and sell.

What do you mean when you say passive and active?

Many would say Warren Buffett is a “passive” investor because he doesn’t often change his portfolio. This is obviously absurd. He is making active decisions about what stocks to buy and hold. A passive strategy simply tries to capture the overall market return. The active investor tries to beat the market return.

The one thing we certainly don’t want to do is pay the higher fee for a swift decision maker that manages their portfolio in a way that looks a lot like the index. This type of manager is called a ‘closet indexer’.

What is the problem with closet indexing?

The problem with closet indexing is that you wind up paying substantial fees for a fund that delivers little in the way of independent investing judgment or risk mitigation. There really is no defence of closet indexing; it makes little sense to pay for active management that is not pulling its weight. It’s even harder to rationalize investing in an “active” fund that is simply mimicking an index but charging 10 times more than the passive option.

How do you know if your manager is active or just actively passive?

Weeding out these closet indexers takes some time and diligence.There are several tools available to help us determine how active or passive a fund is. Each measure in isolation does not lead to a conclusion, however, looking at the measures in conjunction with one another gives a clearer picture.

What is a measure you use?

One measure is called active share. A fund with an active share of zero has holdings that are identical to the underlying index. A fund with an active share of 100 has nothing in common with the index. A fund can achieve a high score by including stocks that aren’t in the benchmark, by excluding stocks that are in the benchmark, or by holding the same stocks but in different proportions than the index does.

What is another known measure?

Another such measure is known as R-Squared. This measures how much of a fund’s movement is explained by the changes in the underlying index. A measure of 1.00 would indicate a perfect correlation while a measure of 0.00 would indicate no correlation.
The combination of a low active share measure and a high R-Squared measure would point to a likely culprit of closet indexing.

If you are like most Boards and Committees, you or your members are paying substantial fees to the managers. Make sure you are getting what it is you believe you are paying for