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Ian McGugan

Canada has become the world leader in a particularly insidious form of financial malpractice. It's a shameful distinction we should aim to lose as quickly as possible.

The sin in question is known as closet indexing. It's the financial industry's less-than-charming habit of charging big fees for mutual funds that are supposed to be actively managed but actually hug a market benchmark.

A paper to be published in a coming issue of the Journal of Financial Economics shows that closet indexing is widespread around the world. However, by one measure, 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.

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.

By comparison, only 15 per cent of the net assets in equity mutual funds sold in the United States are in closet indexers.

Wherever they operate, purveyors of closet-indexing products are misleading their customers. Those clients think they're buying a fund that is conducting its own research and actively weighing the merits of hundreds of stocks. In fact, the buyers are actually getting a fund that closely resembles a market index, like the S&P/TSX composite or the S&P 500, with little evidence of independent thought.

Mislabelling aside, what makes this wrong is that actively managed funds usually charge much higher fees than funds that are upfront about their plans to merely mimic an index.

There's a good chance that your own portfolio harbours some examples of this nastiness. If so, you're overpaying for a deceptively labelled product and putting a dent in your long-term returns.

The new paper 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.

Judged by that standard, only about 55 per cent of the equity mutual funds available in Canada in 2010 were truly active. A further 8 per cent of funds were explicit indexers that openly and honestly declared their indexing intentions. The remainder were closet indexers.

There was a huge difference among these groups in terms of fees. The truly active funds imposed total shareholder costs that averaged 2.78 per cent of assets a year, according to Prof. Cremers and his fellow researchers. By comparison, the closet indexers charged annual fees of 2.11 per cent, while the explicit indexers took only 0.41 per cent.

The gap between the 2.11 per cent charged on average by the closet indexers and the 0.41 per cent charged by the explicit indexers amounts to an unfair toll on investors. It's the extra charge that customers are paying, year after year, for independent management they're not receiving.

When factored across the more than $320-billion invested in equity mutual funds in Canada, closet indexing amounts to a billion-dollar-plus tax on gullible investors.

Consumers could protect themselves against closet indexers if it were possible to easily find out a fund's active share, but that information is hard to come by.

That lack of knowledge needs to be addressed. At a minimum, regulators should require funds to prominently declare their active share. Even better would be a rule that would bar funds with active shares of less than, say, 50 from calling themselves actively managed.

Both rules are simple fixes that would help protect investors from an unfair industry practice that is all too prevalent.