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Closet indexing: how to avoid funds that do this


24 Jun 2021 - Contact Sayan Sircar
5 mins read

Closet indexing can a problem for investors in active funds. Here’s how you can detect it.

Closet indexing can be a problem

Table of Contents

Background of mutual fund portfolio construction

Active mutual funds are expected to beat their benchmark indices as much as possible. For this, they charge higher fees (called Total Expense Ratio or TER) compared to index funds (which give returns comparable returns as the benchmark at much lower fees).

Active funds construct their portfolios in two ways:

1. Top-down construction

The fund manager starts with first the economy and the benchmark index and

  • identifies the sectors that make up the benchmark
  • identifies which sectors will have similar weights as the index in the fund, and which will be higher or lower as per their understanding of return potential based on economic and other factors
  • for each sector then the fund manager chooses individual stocks in the sector and just like the above step assigns weights as same, lower or higher as in the index

2. Bottom up construction

Here the fund manager starts with a collection of stocks first and builds a portfolio from the ground up by

  • analysing the fundamental attributes of each stock
  • determining how much each stock can contribute to the portfolio

Passive funds i.e. index funds simple buy stocks (or bond) in the index in the same proportion as the index and maintain that at every rebalancing period.

Given the way the two funds are constructed, active funds are expected to give higher returns than index funds, after expenses

What is closet indexing?

Closet indexing happens when an active fund’s portfolio is very close to the underlying benchmark. This leads to two problems:

  • only a small part of the portfolio is truly “active” which is unjustified given the TER difference with index funds
  • going forward, it will become increasingly difficult for the active fund to continue beating the index

This is essentially a form of the agency problem. An investor is paying high fees in the belief that the fund manager is doing everything possible to beat the index, but in reality, the fees are being pocketed while keeping the portfolio very close to the index.

While it is easier to lead to closet indexing in the case of top-down portfolio construction, the phenomenon is present even when portfolios are constructed in a bottom-up approach. The phenomenon is more prevalent in mutual fund categories where it is increasingly difficult to beat the index like large-cap funds.


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How to find out if a fund is a closet indexer

This is can be found in two ways:

1. Active Share

Go to

  • AMC website and pick up the fund constituents and weights as per the latest month-end disclosure date
  • NSE website and download the index constituents and weights of the benchmark index for the same date. In the absence of this data, choose an index fund that has the same benchmark

Calculate the number called active share using this data. Active share measures how “active” the fund portfolio is. This figure will be close to zero for index funds and a high figure for active funds. Closet indexers will be in the middle. If a fund claims to be an active fund and the active share is on the low side (or falling with time) then it is a closet indexer. It means that the fund manager is finding it challenging to beat the index which is giving high returns and is justifying their existence by closely hugging the index. The investor is being taken for a ride.

Active share = 1/2 of sum (absolute difference of (weights in fund and weights in index)).

Assume the following funds and index compositions:

  • Index fund: [{A,20%},{B,80%}], TER = 0.2%
  • Active fund X: [{A,30%},{B,50%},{C,20%}], TER = 1%
  • Active fund Y: [{A,30%},{B,70%}], TER = 0.8%

where A, B, C are stocks and the numbers beside are weights. Then

  • Active share for X = 1/2 * (abs(20-30)+abs(80-50)+abs(0-20))% = 1/2 * (10+30+20)% = 30%
  • Active share for Y = 1/2 * (abs(20-30)+abs(80-70))% = 1/2 * (10+10)% = 10%

where abs(10-20) = abs (20-10) is the absolute value function.

Here it is very clear that X is making some effort in “active” investing by choosing another stock C that is not there in the index while Y is hugging the index with the same stocks and very similar weights. While it cannot be predicted which fund X and Y will outperform the index in the future, X is asking for 0.8% extra expenses over the index fund while for Y it should be difficult to justify the extra 0.6% TER over the index fund for not doing much at all.

2. R-Squared

Another measure, called R-squared, can be used to quickly filter for closet indexing funds. R-squared will tell you how much the fund returns are similar to the index returns. Higher the R-squared figure (between 0 to 100%), the more closely the fund tracks the index and is likely to be a closet indexer. Portals like Valueresearchonline have this number for all equity funds. When calculating R-squared, and if the figure is low, check that the right index is chosen to calculate R-squared.

Conclusion

When choosing new active funds or reviewing existing active funds, investors should review

  • the trend of active share and be wary if it is decreasing over time
  • the value of R-squared and note if it is very high or increasing over time

This indicates the fund is slowly becoming more and more index-like. This should be an important part of the mutual fund review process. Closet indexing is one of the reasons investors should consider investing in index funds for the majority of their holdings.

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This post titled Closet indexing: how to avoid funds that do this first appeared on 24 Jun 2021 at https://arthgyaan.com


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