When it comes to investing, it’s essential to be aware of the various strategies and techniques employed by investment managers. One such strategy is known as “closet indexing”.
Closet indexing, also known as “index hugging”, is an investment strategy used by some investment managers that closely mirrors the performance of a benchmark index, such as the S&P 500. The goal of this strategy is to give the impression that the fund is actively managed, but in reality the investment manager is deviating very little from the index that the fund is supposed to outperform.
In this blog post, we delve into closet indexing, its potential drawbacks, how to spot it, and whether you should consider avoiding it.
Understanding Closet Indexing
While active fund management involves making strategic investment decisions to outperform the market, closet indexing implies that the fund is essentially behaving like a passively managed index fund. With this strategy, the portfolio might hold a similar composition of securities as the benchmark index (i.e. S&P 500), which in turn results in performance that closely mirrors the index’s return.
Difference Between Active and Passive Investing
Active fund management and closet indexing represent two different approaches to portfolio management.
Active Fund Management
With active fund management, investment managers analyze market trends, economic indicators, and company performance to identify areas of opportunity and risk. These managers actively buy and sell stocks, bonds, and other holdings with the goal of outperforming a specific benchmark or index.
When working with an investment advisor who actively manages your portfolio, like Prudent Investors, managers have the flexibility to make strategic asset allocations, sector bets, and security selections based on their financial acumen and economic outlook.
Passively Managed Funds
Whereas investment managers who follow active fund management have the flexibility to buy and sell based on their own personal judgment and expertise, managers, managers who passively manage their client’s portfolios are essentially replicating the composition of an index and avoid making bold investment decisions. With this strategy, investors may not experience the level of outperformance they would expect from true active management.
Drawbacks of Closet Indexing
One of the main criticisms of closet indexing is that it restricts potential return. By closely tracking the index’s performance, investors may miss out on opportunities to generate additional returns through active management.
In most cases, investors in benchmark-hugging funds may be paying fees that are lower than actively managed funds. However, passively managed funds are often marketed as actively managed, so it’s important that the investor has full transparency into the manager’s investment strategy before committing to the partnership.
Considerations for Fiduciaries
For professional fiduciaries and family trustees who are bound by the rules of the Uniform Prudent Investor Act (UPIA), closet indexing may present a compliance risk. The UPIA emphasizes the importance of a diversified portfolio, taking into account risk and return objectives for the beneficiaries. Index hugging can unknowingly expose investors to highly correlated sectors or stocks within the index.
For example, tech giants Facebook, Amazon, Apple, Netflix, and Google (also known as the “FAANG stocks”) make up roughly 20% of the S&P 500 alone. When the portfolio becomes too concentrated in a specific sector, bond, or stock the portfolio takes on higher risk and in turn can create liability for the fiduciary. The fiduciary must carefully consider which investment strategy best suits the goals of the trust under the criteria of the UPIA.
How to Spot and Avoid Closet Indexing
According to CornerCap Institutional, closet indexing was less than 5% of U.S. mutual fund assets in 1985 and as of 2013 had grown to over 30%.
Since this strategy is gaining momentum, you may be wondering how to spot and avoid closet indexing. If you’ve decided closet indexing is not right for you or the investments you oversee, first start by performing careful due diligence to understand how your current investment manager is investing your assets. If you are interviewing potential investment managers, this is also a good time to question their investment strategies and whether they actively or passively manage funds.
A question to ask your advisor is what is the benchmark they use for performance analysis and reporting. This benchmark will give you insight as to the investment manager’s style, and also might give some hints as to which benchmark the manager could be indexing to. Oftentimes a manager might have a composite benchmark, such as 60% S&P 500 and 40% Barclays Aggregate Bond Index. With composite benchmarks, the manager might be closet indexing on either the equity or fixed income slice.
Fund managers are generally required to provide clear and accurate disclosure regarding their investment strategies, including whether they passively manage funds or engage in closet indexing. Governing authorities, like the Securities and Exchange Commission (SEC) emphasize the importance of transparency and full disclosure to enable investors to make informed decisions.
If you have concerns that your investment manager is engaging in closet indexing even after they have denied the strategy, here are a few more technical indicators.
R-Squared (R²): R-squared is a statistical measure that represents the proportion of a fund’s movements that can be explained by movements in its benchmark index. A high R-squared value, close to 1, may suggest that the fund closely tracks the benchmark.
Tracking Error: Tracking error measures the standard deviation of the difference in performance between a fund and its benchmark. A low tracking error could indicate that the fund is closely hugging the benchmark.
Analysis of Holdings: Review the fund’s portfolio holdings and compare them with the benchmark index. If the majority of the holdings are similar or identical to those of the benchmark, it could be a sign of closet indexing.
Manager’s Incentives: Consider the incentives of the investment manager. If the manager’s compensation is tied to benchmarks or if there are no performance-based fees, there may be less motivation to deviate significantly from the benchmark.
Regulatory Filings and Disclosures: Examine regulatory filings, prospectuses, and other fund disclosures. Investment managers are required to provide information about their investment strategy, and any discrepancies between the stated strategy and the actual portfolio holdings could indicate closet indexing.
It’s important to note that not all funds that closely track benchmarks are intentionally engaging in closet indexing. Investors should carefully evaluate fund make up, performance, and disclosures to understand the entirety of the investment strategy.
The Benefits of Active Investing
Your investment goals and time horizon should play a vital role in determining whether closet indexing or active fund management is suitable for you. If your goal is to beat the performance of a specific benchmark index, active fund management may be the best option.
Active investing gives managers the freedom to explore new and innovative investment strategies that may not be reflected in traditional indexes. While market timing is challenging, this form of investing also gives managers clearance to attempt to time the market based on cycles, valuations, and economic indicators.
Investors interested in actively managed funds should carefully review the manager’s investment strategy, portfolio holdings, and historical performance to ensure they are getting the level of active management they desire.
Selecting the Right Option for You
Closet indexing can be a controversial investment strategy, appealing to some investors while underwhelming others. Ultimately, the decision to invest in closet indexing or avoid it should be based on your personal risk tolerance, investment goals, and understanding of the strategy’s potential drawbacks.
As with any investment decision, it’s crucial to conduct thorough research, seek professional advice, and carefully evaluate your options before making a choice that aligns with your financial objectives.
Prudent Investors is a fee-only SEC-registered investment advisor providing portfolio management under a fiduciary standard of care, meaning we are legally bound to put your financial interests above our own. Our investment strategy includes active fund management, where we create and evaluate portfolios for diversification across asset classes, sectors, equities, and volatility. Our investment management team regularly reviews fundamental economic conditions such as interest rates, equities, credit, and market sentiment. If you are interested in working with an investment advisor who is as invested in your financial goals as you are, we invite you to connect with our team today.
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