Funds in the Closet

Barrons and the Wall Street Journal both had pieces on closet indexing and the importance of active management in picking good fund managers today.  It is particularly important in picking large cap US equity funds.  Large cap US equities have long been considered one of the more efficient parts of the stock market, with copious amounts of research coverage, data dissemination and many funds.  In this type of situation, it is difficult to stand out and outperform.  The additional pressure to conform to style boxes for various pension and 401k consultants has compounded the issue.  Staying true to a proven investment strategy (not style) may make it difficult for consultants to neatly categorize a fund or manager and thus eliminate it from consideration.

 

Unfortunately, many fund firms and managers have opted to avoid this issue and become closet indexers.  While claiming active management, these funds do not drift far from benchmark weightings and so never drift too far from benchmark performance.  So in effect, very often investors end up paying for active management and getting index like performance.  While this may satisfy some behavioral aspects of investing (the desire to outperform, the fear of loss), it does not make sense from an economic sense.  A lot of time and effort appear to be wasted researching and explaining why this fund outperformed or underperformed by 25 basis points.  It would be much easier to just buy low cost index funds or ETF's for that purpose and use the time to pick a true active manager that can outperform over time.  Since their portfolios typically do not look like an index, the returns carry much more from the index and can scare an undisciplined investor out.  Therefore, this requires a deep understanding of the investment strategy and discipline to ride it out through the inevitable periods of underperformance.  For retail investors, this is where a skilled and disciplined investment professional can make a difference.  However, you have to be careful in picking an advisor, because they may be susceptible to the same pressures.  If you are looking for active managers and they pick closet indexers for you, you would end up paying twice for something you don't want.