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MUTUAL FUNDS

Just how hard are managers working?

By Mark Jewell
Associated Press / December 5, 2010

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It’s becoming more difficult for mutual fund mangers to hide.

Although active management is all about stock-picking prowess, some fund managers essentially follow a market index — “closet indexers’’ is the derogatory term the industry uses. And in a time when investors are particularly sensitive about fees, these managers are getting noticed.

Credit an analytical tool that a pair of Yale professors devised to identify closet index funds. These funds charge higher fees than index funds, yet timidly run their investment portfolios more like those lower-cost alternatives.

These managers don’t stray far from their funds’ benchmark stock indexes. Any marginal reward they might earn for investors largely disappears once the higher expenses are subtracted.

Truly active funds and index funds both beat closet index funds year after year, dating to 1990, the first year the professors compared performance data. After subtracting fees, the most active among the stock-pickers beat their benchmarks by 1.26 percent per year, while the closet index funds lagged behind their benchmarks.

“Closet indexers, unsurprisingly, exhibit zero skill but underperform because of their expenses,’’ says Martijn Cremers, an associate finance professor.

Nevertheless, the closet is getting more crowded. Cremers and former Yale colleague Antti Petajisto concluded that fund managers have become less active as stock pickers over the years, and more likely to stick close to an index — perhaps out of fear they’ll hurt their careers if they trail their benchmark every so often.

Petajisto, now of New York University, also found in newly published research that the shift toward closet index management became more pronounced during and after the stock market meltdown of 2008. He found that about one-third of active managers were actually closet indexers at the end of last year.

What constitutes closet indexing is subjective, but the professors settled on funds with 40 percent or more of their portfolio consisting of stocks in the fund’s benchmark index.

The professors developed a tool they call active share that measures the percentage of a fund’s portfolio that differs from its benchmark, based on the stocks the fund holds. A fund with a 90 percent active share, for example, is sharply different from its index, with just 10 percent overlap with its benchmark.

Active share is potentially useful for predicting fund returns, alongside other more important factors like expenses, says Russel Kinnel, director of fund research at Morningstar.

Cremers and Petajisto studied some 3,000 US stock funds and found many whose managers were aggressive, with more than 90 percent active shares. Some held just a few dozen stocks in their portfolios, setting themselves apart from their much-broader benchmarks.

But other funds the professors consider closet indexers held hundreds of stocks, making it hard to distance themselves from the pack. In some instances, they mostly mirrored their benchmarks, with active shares of just 40 percent.

Morningstar’s Kinnel says his own research demonstrates the tool has a bias that makes it appear managers of funds specializing in large-company stocks are more likely to be closet indexers. That’s because small- and midcap managers typically have more stocks to choose from, so are more likely to depart from their benchmark indexes.

Cremers concedes the tool shouldn’t be the first measure investors rely on to compare fund options. “But it at least can give investors a sense what is under the hood,’’ he says.

In any case, there’s not yet a quick, easy way for average investors to calculate a fund’s active share. For now, Cremers says, one way to screen out closet index funds is to check its top holdings, and see whether they’re also found in the fund’s benchmark. If there’s a big overlap, he says, “the fund will have a very hard time beating the market.’’