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Friday, August 18, 2006

Is Your Fund Manager a "Closet Indexer"? (from the WSJ)

Is your mutual fund manager a "Closet Indexers? A "closet indexer" charges active management-level advisory fees, but invests more like an index fund. Today's Wall Street Journal highlights the practice, and discusses some academic research that measures the extent to which a fund is a "closet indexer":
A complaint lodged against many managers of funds that invest in stocks is that they collect big fees for doing little more than basing their stock picks on the market index -- say, the Standard & Poor's 500-stock index -- against which their fund's performance is measured. There's even a term for this behavior: closet indexing.

For investors, there hasn't been an easy way to tell if a fund falls into this category. Now a pair of Yale University professors have developed a simple way of measuring to what degree a fund's holdings are actively managed, as opposed to passively mirroring an index. It also turns out that -- at least according to the research -- this measure could be a useful predictor of fund performance.

The new measure, created by Antti Petajisto and Martijn Cremers from the Yale School of Management, takes a simple approach. Called the "active share" of a portfolio, it matches the holdings reported by a fund in Securities and Exchange Commission filings against the components of an index, and then measures the percentage of overlap. For example, if General Electric and Exxon Mobil each account for 4% of an index, and a fund had a portfolio exactly mirroring the index except it had 8% in GE and nothing in Exxon, its active share would be 4%. The more a portfolio differs from an index, the higher the active share percentage.

The study found that the average fund using the S&P 500 as a benchmark (generally, funds investing in large-company stocks) has an average active-share percentage of 66%. In other words, the average large-company stock fund had a portfolio that was 66% different than the benchmark and the rest essentially mirrored the index.

You can read the whole article here.

The article, titled "How Active is Your Fund Manager? A New Measure That Predicts Performance" can be downloaded from the SSRN here. In case you just want the abstract, here it is:

To quantify active portfolio management, we introduce a new measure we label Active Share. It describes the share of portfolio holdings that differ from the portfolio's benchmark index. We show that to determine the type of active management for a portfolio, we need to measure it in two dimensions using both Active Share and tracking error. We apply this approach to the universe of all-equity mutual funds to characterize how much and what type of active management they practice. We test how active management is related to characteristics such as fund size, expenses, and turnover in the cross-section, and we look at the evolution of active management over time. We also test how active management is related to fund performance. The funds with the highest Active Share significantly outperform their benchmark indexes both before and after expenses, while the non-index funds with the lowest Active Share underperform. The most active stock pickers tend to create value for investors while factor bets and closet indexing tend to destroy value.

So, the closet indexers tend to underperform the indexes even before expenses. Of course, after expenses, they're even further behind.

But interestingly, those who are most active (those who are least in the closet indexer camp) perform best. This is consistent with the notion that actively managed funds have better talent than the closet indexers.

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