Closet index funds are actively managed funds whose portfolios closely mirror the basket of stocks in an index. In Canada, they charge an average annual management fee of 2.4% to provide performance similar to exchange-traded funds (ETFs) charging 0.2% or less per year.
Closet index funds arise when funds become so big its almost impossible to differentiatefrom the market. Theyalso arise when managers seek job safety. It is better to fail conventionally, than succeed unconventionally, said John Maynard Keynes.
How many closet index funds are there? Preet Banerjee of Pro-Financial Asset Management estimated last spring 40% of mutual fund assets in Canada fit this description (based on 90% or more correlation between index and fund, as measured by the R-squared statistic). In 2005, Morningstar Canada estimated that 70% to 85% of Canadian equity funds fell intoin this category (based on their Industry Sector Concentration measure). Dan Hallett of Highview Financial Group has commented on some of the finer points in measuring the sector’s size,and taking them into account could yield yet another estimate.
Investors would seem to be better off buyingbroad-market ETFs. Orbuying actively managed funds different from the indexes, if they want a shot at beating the market . One way to spot the latter kind of fund: a concentrated portfolio of 20 to 30 stock holdings. Another way: sector weighting different than the index.