"Closet indexing" refers to a strategy where funds engage in active investment by selecting securities, yet their portfolios closely mimic a benchmark, such as the S&P 500. This approach allows portfolio managers to attain returns comparable to the index without directly replicating it.
Closet indexing is also known as ‘index hugging’, where the investment strategy aims to give the impression that an investment fund is being actively managed. However, the reality is different because the fund manager only slightly deviates from the indexes that have to be outperformed by the fund.
In this article, we will understand what closet investing is, how it works, some of its drawbacks, and how to spot and avoid closet indexing.
What is the meaning of closet indexing?
Closet indexing occurs when an actively managed fund resembles the underlying benchmarks very closely. In most active funds, strategic investment decisions are made to ensure the fund delivers more than the market's performance. However, in closet indexing, since the composition of securities and financial instruments is similar to market benchmarks, the fund starts behaving like a passively managed fund.
In reality, only a small portion of the fund is actively managed, while its majority holdings are similar to index funds. With time, it will start becoming difficult for closet funds to beat the market benchmarks.
This is an area of concern for investors as they end up paying high fees to AMCs, institutions, or fund managers to beat the market return when, in reality, their portfolio has a performance similar to that of an index. The fees are pocketed without delivering stand-out results.
How does closet indexing work?
Closet indexing occurs when a fund closely mirrors an index in terms of weighting, industry sector, or geography. Fund managers, whose performance is typically benchmarked against an index, are often incentivised to achieve returns similar to the index. Managers can still be praised for their stock-picking skills even if the fund slightly underperforms the benchmark after fees.
Investors often view closet indexing negatively because they could simply invest in a lower-fee index fund. Identifying closet indexing can be challenging, but reviewing the fund’s prospectus can reveal its true holdings. Several tools can help spot funds that mimic a benchmark index, including R-squared, tracking error, and active share.
Drawbacks of closet indexing
The main argument against closet indexing is that it reduces the investor's earning potential. By closing mimicking the holdings and asset allocation of benchmark funds, investors end up missing potential opportunities that would likely produce more returns had they been managed actively.
Investors also end up paying high fees for passively managed investments. Because the investor is unaware and the AMC or the fund manager did not disclose their strategy, investors continue to pay higher charges for performances that are mediocre.
How to spot and avoid closet indexing?
The first step to spotting and avoiding closet indexing is to ask your fund managers relevant questions about their investment strategy and whether their funds are being managed actively or passively.
Fund managers must also disclose and provide a clear explanation of their investment strategies, whether active or passive. SEBI has made it mandatory to ensure complete transparency and disclosure so that investors can make informed decisions.
If you are concerned that your investment manager might be engaging in closet indexing despite their claims otherwise, here are some technical indicators to look out for:
R-squared (R²): This statistical measure reveals the extent to which a fund’s movements align with changes in its benchmark index. A high R-squared value nearing 1 suggests the fund closely mirrors the benchmark.
Tracking error: This metric gauges the standard deviation of performance differences between a fund and its benchmark. A low tracking error indicates the fund closely matches the benchmark’s performance.
Analysis of holdings: Evaluate the fund’s portfolio against the benchmark index. Significant similarities or identical holdings may indicate closet indexing.
Manager’s incentives: Assess how the investment manager is motivated. If their compensation is tied to benchmark performance or lacks performance-based fees, they may have less incentive to diverge significantly from the benchmark.
Regulatory filings and disclosures: Scrutinise regulatory filings, prospectuses, and other disclosures. Investment managers are obligated to outline their investment strategy. Inconsistencies between the stated strategy and actual holdings could suggest closet indexing.
Selecting the right option for you
Closet investing appeals to some investors, while others find it a waste of their capital and underwhelming. However, the final decision about whether to invest in a closet index depends on several factors, namely your investment objective, risk appetite, and understanding of the investment strategy being used.
It is important to conduct thorough research, seek advice from experienced professionals, and carefully evaluate all your options before making a choice that aligns with your financial objectives.
Key takeaways
- Closet indexing is a strategy for purchasing funds that are made to resemble actively managed funds. However, these funds end up following a portfolio similar to the benchmark they were trying to outperform.
- Closet funds are considered controversial in the investment landscape and are also looked down upon. They charge high fees from their investors but, in return, only mirror their closest benchmarks, providing an illusion of fund management skills.
- Metrics like R-squared and active share can help identify a portfolio's deviation from its benchmark index and thereby determine whether it is engaged in closet indexing.
Conclusion
Closet index funds just mimic or shadow a good-performing market benchmark. However, they charge nearly 4–5 times that of normal benchmark funds. Closet indexing can lead to added costs for investors. As an informed investor who can make effective decisions, you must research and understand costs and management style to ensure you are investing in the right instrument. Three techniques come in handy here: R-squared, tracking error, and the number of active shares, which help you identify closet indexing.
