Beware Closet Indexers

by: Roger Nusbaum

A reader pointed out this article at Seeking Alpha about the Norway Government Pension Fund--Norway's sovereign wealth fund.

The article has several bullet points discussed including one about avoiding inadvertent indexing. The idea here was not to avoid indexing but to avoid paying an active management fee for what amounts to an indexed portfolio. Chances are you've heard the term closet indexer. This refers to funds or managed accounts that quack like some broad based index.

There are at least two reasons why a managed fund would look a lot like an index one, one of which is something called career risk. The idea here is that it is ok to be wrong if you're wrong in the same way as everyone else. I think a good example of this was the extent to which many well known managers were overweight financial stocks five years ago. Another example would be being overweight tech stocks 12 years ago.

Another reason would be size. When a fund has many billions in AUM it becomes difficult to stray from the index because it can't really buy small stocks, it would have to buy half the company to move the needle for the fund.

Click to enlarge

The above chart is an actively managed, global equity fund (name and symbol removed) that charges a fee that is well within the range of normal for an actively managed fund. The fund's result is in blue and its Morningstar benchmark is in orange. I doubt the fund's marketing is "we're going to look just like the index but charge you a lot more!"

Looking like an index now and then is inevitable but in my opinion that does not have to mean a result like the above chart. I would note this does not have to be about performance in terms of a fund manager saying they will beat the market every quarter or every year. I would think that any manager would have some sort of philosophy and they need to articulately convey that to anyone who is thinking of hiring them so that there is not a mismatch in expectations. For example we are not worried about beating the market for a given quarter (without looking, how'd you do in Q2, 2010?) but there are investors who do need to beat the market for the quarter so that person would be a bad fit with our firm as an example.

To be clear, indexing is a valid way to invest. It may not be right for everyone, no method is, but it is valid. The point being made is that no one should pay 1.5% for what amounts to an indexed portfolio. Another point of differentiation to make is an active strategy using index funds. There are managers having success with active strategies that use passive funds.