Are you investing in closet index funds?

Investors pay higher management fees for actively managed funds. Many are wondering whether active management really yields better results over time. Would it be reasonable to just invest in an index fund and seek average market return? Passively managed index funds also have the added benefit of low costs. However, according to a recent study, a surprisingly high proportion of the funds marketed as actively managed and hence with higher management fees are in reality funds that mirror the average market development. In other words: closet index funds.

Only a couple of per cent of Finnish fund investments are targeted at index funds (Cremers, Ferreira, Matos and Starks, 2013). This comes as no surprise. According to the same source, around 50 per cent of Finnish fund investments are made in actively managed funds. The calculation does not match. Where are the remaining more than 40 per cent of the funds? The aforementioned study calls them ‘closet index funds’. In other words, funds that are sold as actively managed but that in reality mirror the index.

What is this all about? Index funds are passively managed funds that follow or mirror the market development. Those who invest in an index fund attain the average market return. Passively managed funds generally have low management fees.

The management fees of actively managed funds are higher than those of index funds. Investors are willing to pay a higher fee, because they believe that the portfolio manager’s outlook leads to a better-than-average return. Active management is thus something people are willing to pay for. This means that selling an index fund as an actively managed fund is a hoax.

The Finnish phenomenon is not unique. The same happens in other EU countries as well. Of the benchmark countries, the proportion of ‘closet index funds’ was the smallest in the United States. On the other hand, the proportion of index fund investments was largest in Switzerland, while the proportion of actively managed funds was largest in Liechtenstein.

The study invites the reader to compare the costs and the content of funds. What kind of funds does your portfolio contain?