It’s time to shed a bright light on one of Bay Street’s most annoying and well-hidden practices.
It’s known as “closet indexing” and occurs when a financial planner, bank or mutual fund company sells you a fund that is supposed to be actively managed but actually hugs the market benchmark.
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. The extra charge – compared to what you could pay for a plain-vanilla exchange-traded fund that cheaply and efficiently tracks the same index – typically amounts to somewhere between one and two percentage points a year.
If you think that doesn’t sound so bad, think again. Over the course of a decade, those fattened fees, if applied to an equity portfolio worth $100,000, could wind up dinging you for more than $10,000 in added charges without the assurance of any compensating gain in performance.
New research suggests that Canada’s mutual fund industry has earned the dubious distinction of being the world leader in closet indexing. In their paper, Indexing and Active Fund Management: International Evidence,” four professors of finance – Martijn Cremers of Notre Dame, Miguel Ferreira of the Nova School of Business and Economics, Pedro Matos of the University of Virginia and Laura Starks of the University of Texas at Austin – estimate that about 37 per cent of the assets in equity mutual funds sold in Canada are in closet indexers.
This is disturbing. What makes it worse is that typical investors have had no easy way to identify funds that are closet indexers.
Until now, that is. With the help of Morningstar Canada, we would like to turn a spotlight on Canada’s closet indexers. The accompanying tables, provided by Morningstar, show how Canada’s biggest funds compare in terms of their investing independence.
The tables rely upon a simple but informative measure known as “active share.” Developed nearly a decade ago by Prof. Cremers and Antti Petajisto, a former Yale University finance professor, the indicator measures how much a fund’s portfolio deviates from its benchmark.
A fund with an active share of 0 is 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.
How high does a fund have to score to dispel any suspicion that it is a closet indexer? Prof. Cremers and his co-authors draw the line at an active share of 60. If a fund has an active share below that number, the academics deem it to be a closet indexer.
Mutual fund companies blame the low active share numbers on Canada’s relatively small stock market, where a big slice of the total market value is represented by a mere handful of companies – big banks, large insurers and major energy producers.
“Canadian benchmarks are significantly more concentrated than other global benchmarks including the S&P 500 and MSCI World,” says Milos Vukovic, vice-president of investment policy at RBC Global Asset Management Inc. As a result, he says, it’s more difficult for a fund to deviate from the market benchmark in Canada than it is in countries with broader, more diversified stock markets. Mr. Vukovic argues “it’s not appropriate to compare active share across different regions.”
That’s a reasonable objection. The active shares of funds that invest in global markets tend to be higher than the comparable numbers for Canadian equity funds – a fact demonstrated in our listing of Canada’s largest mutual funds.
However, the narrow confines of this country’s stock market don’t provide an all-encompassing alibi for closet indexing. Despite the structural issue, some Canadian equity funds do succeed in achieving high active shares.
What’s more, the key defence offered by the mutual fund industry – that the market is so concentrated, it’s hard to be different – can also be used as evidence for the prosecution. If the domestic market is so constrained, why not just passively track it with an index fund?
Exchange-traded funds (ETFs) that follow the broad Canadian market charge a slender fraction of a percentage point, which is far below the typical levy for a Canadian equity fund. Over the long haul, those low-cost ETFs tend to be a good deal since they give you the market return with only minimal costs deducted.
To be sure, some funds with low active shares have nevertheless beaten the market. Some investors simply prefer their money to be actively managed.
But even active-management loyalists should make a practice of asking for a fund’s active share before buying it. If a fund has a low active share but nevertheless charges high fees, a customer should be skeptical of how much value it’s adding. And that skepticism should grow if the fund has demonstrated no history of beating the index.
Any discussion of active-share measurement and closet indexing inevitably leads to many questions. Here are the answers to some of the more common queries.
Does active share tell you everything you need to know about a fund’s penchant for closet indexing?
“No one metric tells the entire story,” says Christopher Davis, director of manager research for Canada at Morningstar Inc. “Active share is simply a good starting point for indicating whether a manager is doing something substantially different than the index.”
Mr. Davis says other metrics can add important information. For instance, “tracking error” measures the standard deviation of a fund’s returns from that of the benchmark’s. Morningstar has included tracking error in the online tables.
Are funds with a low active share doomed to disappoint?
No. Some funds with a low active share have beaten the market. One shining example is the RBC Canadian Dividend Fund, which has produced market-beating results despite a low active share that indicates it is hewing rather closely to the index.
But such cases are not the rule. Martijn Cremers of the University of Notre Dame and Antti Petajisto, now of asset manager BlackRock, found that high-active-share funds in the United States have historically done better than their reported benchmarks and better than low-active-share funds.
So should you select the fund with the highest active share?
Sadly, it’s not quite that simple. A high active share is a measure of how much active risk a fund is taking on, but more risk doesn’t necessarily ensure better performance if a manager is simply scrambling around.
“If a manager is unskilled and highly active, that’s the worst combination of all,” Mr. Davis says.
To further complicate matters, active share is very sensitive to what benchmark is used. A fund may look very active compared to the S&P/TSX composite but not very active at all compared to the S&P/TSX Canadian Dividend Aristocrats Index. It’s also far easier for a fund that invests in global markets to show a high active share than one that invests only in Canadian stocks, since the global index is likely to consist of many more stocks than the Canadian index.
Three researchers at AQR Capital Management LLC published a paper this spring that argues that much of the apparent superiority of high-active-share managers is really the result of lumping together funds that should be compared to different benchmarks.
The researchers – Andrea Frazzini, Jacques Friedman and Lukasz Pomorski – conclude that active share is not a useful measure of skill. However, they agree it can be useful in evaluating fees.
“In general, fees should be commensurate with the active risks funds take,” they write. “If you deliver index-like returns, you should charge index-fund-like fees.”
Those are words that Canadian funds – and investors – should keep in mind.