Closet Indexing By Mutual Funds: Worse Than We Thought?

We've used this space to draw attention to an under-appreciated problem in financial services: big, diversified mutual funds that behave more like their underlying benchmarks than true instruments of "active management." (Click here for an August post that links to a couple other items we've written on this topic.)

In the March issue of the Exchange-Traded Funds Report (subscription required), we ran across an intriguing passage in the edited transcript of a roundtable discussion of the ETF marketplace. Here's the exchange, between a questioner and panelist Joe Keenan of Bank of New York Mellon (emphasis added in bold):

Audience Member: It occurs to me that the traditional mutual fund industry -- should they choose to monetize their cash position using ETFs -- could double the size of the industry. I know some funds are indeed using ETFs as a vehicle they're investing in.

Keenan: I'll make one comment only because we do have some intelligence at The Bank of New York Mellon. Just for kicks we run reports as a custodial bank to see who's holding ETFs, and it is extraordinary how many traditional long-only mutual funds hold ETFs, either to equitize their cash or to get the market return and then just layer on fees. You may not see the ETFs held during the reporting periods, but certainly inside those periods. It's not uncommon.

A couple comments. First, it's not inherently wrong for mutual fund managers to equitize cash with ETFs. Depending on a manager's investment discipline and conditions in the relevant asset class, it can be perfectly sensible to combine a set of active opportunities and ETFs for portfolio completion (i.e., a fully- or almost fully-invested fund). We've done as much in our own active program.

But Keenan's remarks reveal a couple serious -- and potentially related -- problems:

(1) reporting-period manipulation designed to conceal the fact that managers are equitizing assets using ETFs and

(2) the cynical laziness of earning market returns and layering on active-management fees.

To the extent that a manager is guilty of (2), he/she/they might use (1) to conceal the ruse.

To summarize: Using ETFs to equitize assets can be a perfectly sensible periodic/short-term tactic. But as ever in this business, we prefer more transparency to less, and thus less subterfuge to more. If managers are using ETFs in their active portfolios, they should freely acknowledge as much, explain their decision-making, and be accountable for their results. Anything less is a breach of managers' fiduciary duty to fund shareholders.

Source

"Past, Present & Future of Exchange-Traded Funds," Exchange-Traded Funds Report, March, 2008 (subscription required)

Comments

[Buck Woodford:]

I'm not one bit surprised.

2008 Apr 09 03:44 PM

[rodcore:]

Great article. Further reason why the mutual fund industry must change or die.

2008 Apr 09 04:58 PM

[The Jackal:]

Not suprised either. Most PM's couldnt punch their way out of a wet paper bag.

2008 Apr 09 06:30 PM