How to Avoid Closet Indexing

There are two broad categories into which investment portfolios, including funds, can be categorized: actively managed and passively managed.

Actively managed portfolios are investment portfolios where the portfolio manager actively monitors the securities markets, and builds a portfolio of individual stocks or bonds based on the portfolio manager’s analysis. The investments that make up the portfolio are chosen based on their perceived ability to provide a good return and not because they are included in the benchmark index. Actively managed portfolios try to provide a higher rate of return than the benchmark index.

Passively managed portfolios are investment portfolios where the portfolio manager does not do any individual security selection. Instead, the portfolio manager merely duplicates the security holdings of the benchmark index at the identical index weightings. The goal is to provide a rate of return as close to that of the benchmark index as possible.

What is Closet Indexing?

Closet Indexing is a strategy that claims to actively manage investments but results in a portfolio that is extremely similar if not almost identical to the benchmark index. Closet Indexers typically achieve returns that are similar to the benchmark index without replicating the benchmark 100%. Closet indexers are selling their clients passively managed portfolios at active management fees.

Impact Of Closet Indexing

• Falsifying Investment Process. The closet index portfolio manager claims to be doing investment research and trying to beat the benchmark index when in fact he/she is doing minimal research, if any, and is content with achieving the benchmark return.
• Active Fees for a Passive Investment. Closet indexers tend to charge active management fees for what is essentially a passively managed portfolio.
• High Tracking Error. Closet index funds or portfolios do not exactly mirror the benchmark index. They have a higher volatility than true passively managed funds or portfolios and often underperform the benchmark.

How to Avoid Closet Indexing

In order to avoid closet index funds or portfolios, you need to know how to identify them.

• R-Squared: Compares the movement of a fund or portfolio to the benchmark index, expressed as a percentage. A true passive fund would have an R-squared of 100% or very close to it. The lower the R-squared the more dissimilar the portfolio is to the benchmark.
• Tracking Error: The difference between a portfolio’s performance and the performance of the benchmark(also expressed as a percentage). A low tracking error implies the fund is tracking the benchmark. Even a passively managed portfolio will have some tracking errors.
• Active Shares: The percentage of shares held in the portfolio that are not in the benchmark index. The higher the active share percentage, the greater the probability the portfolio manager is actively managing the portfolio and the holdings and weightings do not mimic those in the index. Portfolios with high active shares tend to outperform their benchmarks over the long term.

Therefore, to avoid closet index funds, do not purchase funds that claim to be actively managed but have a high R-Squared, low tracking error, and/or a low active share percentage. For non-fund portfolios, discuss your investment manager’s strategy with them and confirm that they are committed to an active management approach. Review your portfolio holdings against those of the benchmark index and ensure that there is little commonality of holdings and weightings.

Have Bloom Actively Manage Your Portfolio

For almost 40 years Bloom Investment Counsel, Inc. has provided actively managed customized portfolios for wealthy individuals, family offices, foundations, corporations, institutions and trusts. To learn how we can help preserve, protect and build your wealth with a customized actively management investment portfolio contact us at info@bloominvestmentcounsel.com or 416–861–9941.

This content is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this content should consult with his or her financial partner or advisor.