By Mark Jewell
AP Personal Finance Writer
BOSTON (AP) -- 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 the fees they're paying, 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 low-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 as well as index funds beat the 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 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 lag their benchmark every so often, Cremers suggests.
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.
Funds with such large proportions of their holdings in the benchmark "really aren't trying hard to beat it," he says.
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.
Although it's not without weaknesses, 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 U.S. 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 themsevlves 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.
One fund that has recently come to resemble a closet index fund is American Funds' Growth Fund of America (AGTHX). It's the largest U.S. stock fund with $156 billion in assets. The fund has a unique structure, since it's divided among 10 managers, each with responsibility for a piece of the portfolio.
As recently as 2003, about 75 percent of the fund differed from its benchmark, the Standard & Poor's 500. But that active share had declined to 55 percent by the end of September.
Petajisto's concluded that decline means the fund's historically strong long-term performance will be hard to maintain, and should be taken as a signal "that the fund's best days are behind it." Over the past 10 years, the fund is in the top 14 percent among its large-growth fund peers.
American Funds spokesman Chuck Freadhoff disputed the contention that the fund is a closet indexer. Growth Fund of America recently held about 8 percent of its portfolio in cash, a buffer against the market's ups and downs that isn't accounted for in active share comparisons.
Freadhoff also noted that the fund recently changed its investing criteria so that as much as 25 percent can be held in foreign stocks, in contrast with the all-U.S. S&P 500.
The fund's performance against its benchmark actually was better in some years when it had a low active share, than in years when it had a high active share, Freadhoff says.
"Active share is an interesting tool, but we don't believe it should be the basis on which an investor makes a long-term decision that will help them reach their financial goals," he says.
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."
Published: Mon, Dec 6, 2010
