Closet Indexing

We picture a portfolio manager diligently researching stocks and other securities and making purchases that are going to provide the best possible returns. In exchange for all this hard work, they are rewarded with management fees paid by clients.

But some portfolio managers take the “easy” way out, or they want to use something more reliable than their own best judgment, so they turn to closet indexing. Just like hiding in a closet or doing something behind closed doors, the portfolio manager claims to be purchasing a variety of investments, but is really going along with an underlying benchmark index such as the S&P 500. Kind of like those whose March Madness brackets are almost identical to what’s published in Sports Illustrated.

Perhaps the reason some managers resort to this is they’ve had several years of poor results and don’t want their company or their clients to lose confidence in their abilities. Portfolio managers are also fiercely competing with “passive management,” where the portfolio matches a market index, known as index funds. Active management funds almost always underperform passive management ones, because they need to achieve a higher return to make up for their higher management fees and trading costs.

So it’s no wonder that portfolio managers turn to closet indexing. But investors are not too happy to find out closet indexing has been going on since they have been paying higher fees, when they could have just invested in an index fund. There is tracking software that measures the percentage of holdings in a fund’s portfolio that differs from the fund’s benchmark index. Called “active share,” if a portfolio has between 20% and 60% that is different, it is believed to be a closet indexer.

In 2018, the New York Attorney General reached an agreement with 13 major fund firms to voluntarily disclose how much closet indexing they do and how much they actively manage their equity funds. Each firm will now come out of the closet and post on their website the active share of funds on a quarterly basis.