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Regulators launch probe into the 'closet indexers' of the mutual fund industry

The OSC is seeking additional information from portfolio managers, including how the securities are selected for their funds.

Peter Power/The Globe and Mail

Regulators are taking a closer look at actively managed funds to determine if portfolio managers are fulfilling their duty – or simply hugging an index.

The Ontario Securities Commission wants to know whether funds that are advertised as actively managed are in fact living up to their name, or whether they are exhibiting a close tracking of their benchmark index, such as the S&P 500 or the S&P/TSX composite index.

An investor pays a higher fee for a mutual fund than for an index fund on the assumption that they are getting active management that could ideally produce better returns.

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But a recent paper published in the Journal of Financial Economics showed that so-called closet indexing is widespread around the world. And by one measure, it found that Canada is where the practice is most prevalent.

About 37 per cent of the assets in equity mutual funds sold in this country are in closet indexers, according to research by Martijn Cremers of the University 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.

By comparison, only 15 per cent of the net assets in equity mutual funds sold in the United States are in closet indexers. The level of closet indexing in Canada is the highest among the 20 countries covered in the paper when it is calculated as a percentage of equity funds sold in each country.

A recent report by the OSC stated that it had "commenced a targeted review of conventional mutual funds that disclose in their prospectus and marketing materials that they pursue active management strategies … Among other data, we considered the funds' active share (a measure of the percentage of a fund's portfolio holdings that differs from the composition of its benchmark index) to assess the extent of active management."

The OSC is currently seeking additional information from portfolio managers, including how the securities are selected for their funds.

"We have written to selected managers of Canadian equity funds to obtain a better understanding of their investment strategies and the reasons why the strategies resulted in investment portfolios that overlap significantly with the composition of their benchmark index," the OSC says in the report.

A spokesperson with the OSC would not elaborate on the review, given that it is continuing.

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The OSC could publish new guidance to the industry once the review is complete. Observers have suggested, for instance, that regulators could require funds to prominently declare their active share.

The paper published in the Journal of Financial Economics identified closet indexers by using the active share formula previously devised by Prof. Cremers and his colleague Antti Petajisto. A fund's active share is essentially equal to the percentage of its portfolio that differs from the benchmark. To qualify as a true active manager for the purposes of the paper, a fund had to have an active share above 60.

As Globe Unlimited subscribers can see from these tables tgam.ca/activeshares1 and tgam.ca/activeshares2, many funds, especially in the Canadian equity area, fall short of meeting that requirement.

With files from reporter Ian McGugan

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About the Author
Globe Investor Reporter

Clare O’Hara is a reporter at The Globe and Mail. Prior to that, Clare spent eight years as a staff writer at Investment Executive, a national newspaper for financial service industry professionals. More

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