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Why Closet Indexing Matters and How You Can Protect Yourself as an Investor

Closet indexing is a strategy in which an active portfolio manager closely mimics the portfolio’s benchmark index. This can be unfavourable for investors because they are paying higher management fees for a portfolio that achieves a return profile similar to the benchmark index.  

This article takes a closer look at closet indexing and discusses why it matters as well as useful methods to protect yourself, as an investor, from active portfolio managers who are closet indexers.

Why Closet Indexing Matters

To understand why closet indexing matters, it is easiest to look at what the job of an active portfolio manager demands. The goal of an active manager is to execute something different than the overall market, either to outperform or have less risk, while taking the investor’s investment goals, risk tolerance and time horizon into consideration.

To do this, an active manager creates and tracks the performance of an investor’s investment portfolio and makes independent buy, hold, and sell decisions based on a stock’s growth and income potential. The decision-making process involves quantitative investment analysis, qualitative research, economic forecasts, and personal judgement based on a wealth of experience. Additionally, some active managers meet and conduct interviews with senior management of companies in which they are contemplating investment. In brief, the overall product an investor pays for when hiring an active portfolio manager is ultimately the actively managed portfolio and the cost for the portfolio manager’s “work” to make research-backed and prudent decisions.

Taking this into account, when a portfolio manager claims to be an active manager, charges active management fees, but is actually largely mimicking the portfolio’s benchmark index, it takes away the promise of active investing. At the end of the day, this harms investors because they may be paying higher, active fees for what is essentially a passive strategy. Investors could have simply bought an index fund and paid lower fees.

How You Can Protect Yourself as an Investor

To see if your active portfolio manager is in fact a closet indexer, you may wish to look at the top holdings and sector weightings to see if they align closely with the benchmark index.

You can also gain more insight on the extent to which your portfolio holdings deviate from the benchmark index by requesting for a metric called active shares—the percentage of a portfolio that differs from the benchmark index. A portfolio with an active share percentage close to 100% means that the portfolio has minimal similarity to its benchmark index.

It is important to note that while a portfolio’s active share may be a predictive indicator for closet indexing, it should be used in conjunction with other indicators as mentioned above.

Closet Indexing Is More Common Than You Think in Canada

The key takeaway is that portfolios that are marketed as active vary in the degree in which the portfolio composition actually differs from the benchmark index. Confident investing requires selecting an investment management firm that provides all the necessary information to make certain that the actively managed portfolio is truly an “actively” managed one. If portfolio holdings align closely with the benchmark index, you may want to switch to a more actively invested portfolio that does not mimic the index and has a greater potential to outperform the index.

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.

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