The pact between a mutual fund investor and the manager of the typical stock mutual fund is, in theory, a simple one: payment in exchange for expert stock selection.
But financial advisers have long complained that there are funds that don't fully live up to that exchange. Those funds charge high fees but follow a strategy that is very close to simply betting on an index. The supposedly active fund manager, in effect, is being paid for doing close to nothing.
Investing with a closet indexer is a double-whammy for investors: It lowers their odds of getting results that are far better than the benchmark, which is a key reason to opt for an active stock picker (although, to be fair, their chances of falling far behind are lower, too). And investors might be paying substantial annual fees, and sometimes sales commissions, for fairly average returns.
In many cases, investors could benefit by moving some money to a cheap index-tracking fund with annual fees of less than 0.2% of assets or by investing with managers who happily veer from the index -- or a combination of both.
"It's hard to make the case for index huggers" that lag behind the index and have higher fees, said Russel Kinnel, the director of fund research at Morningstar. "While the risks to your portfolio aren't great, investors are needlessly settling for mediocrity."
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Looking for copycats
We went looking for closet indexers in one of the largest fund categories -- large-cap-blend funds, which typically compare their performance to the Standard & Poor's 500 Index ($INX). We asked Morningstar to identify funds with "R-squared" scores of more than 98% over the five years through Oct. 31. A fund's R-squared score, which you can figure by comparing the fund's performance to a benchmark, measures the percentage of a fund's returns that can be explained by the index's movements.
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Morningstar excluded from its screen enhanced index funds, which aren't quite index funds but also can't be called closet indexers. They include the Vanguard Growth & Income Fund (VQNPX) and track their benchmarks closely, but they use some active management to try to beat the index or lower volatility. Unlike closet indexers, however, they openly state their intention to stay close to their benchmark.
We also used an "active share" gauge suggested by two Yale University academics, in a paper published in September, which looks at how much a fund's holdings differ from its benchmark. For instance, if a fund that compares itself with the S&P 500 holds 50 of the index's 500 stocks, its active share is 90% -- just 10% of the index is mirrored in the fund. But a fund with an active share below 60% -- indicating it holds at least 40% of the stocks in its index -- could be a closet indexer, say authors K.J. Martijn Cremers and Antti Petajisto, who provided active-share scores for more than 1,000 funds from 1990 to 2006 in their paper.
Controlling risk
R-squared scores and active-share data suggest that closet indexers in the large-cap-blend category may include Thrivent Large Cap Stock Fund (AALGX), which has about $1.7 billion in assets; Principal Large Cap Blend I (PLIIX) and Principal Large Cap Blend II (PLBIX), which have assets of roughly $900 million and $700 million, respectively; and the $900 million Dreyfus Fund (DREVX).Three additional funds that appeared on our screens and have at least $100 million in assets are Dryden Large Cap Core Equity Fund (PTEZX), First Investors Blue Chip Fund (FIBCX) and Nationwide Fund (MUIFX).
In response to their funds appearing on our screens, the companies pointed to what they say are risk-controlled approaches in their strategies.
Randy Welch, the director of investment services at Principal Financial Group, said the Large Cap Blend I and Large Cap Blend II funds don't have to take large bets against the index to outperform peers -- an approach that keeps their risk low relative to the S&P 500.
"It's for people on the outside to determine whether these funds are closet indexers," Welch said. "We consider them to be actively managed. It's just about how much risk we want them to take."
Dreyfus, a unit of Bank of New York Mellon, says in a statement that "good active management is maximizing return per unit of risk." The fund is beating its benchmark this year because of "stock selection and a rigorous investment process for its shareholders," the company said.
Thrivent Financial for Lutherans said in a statement that "prudent risk management is at the core of Thrivent's investment-management process." R-squared isn't a measure of risk, and active share "is not a measurement commonly used by professional money managers," it said.
Matthew Wright, the manager of First Investors's Blue Chip Fund, said the fund's management team focuses on outperforming its peers in Lipper's large-cap-core category and doesn't "spend a lot of time figuring out where we are compared to the S&P 500." Correlation to the S&P 500 is mostly coincidental, he said.
JennisonDryden, a unit of Prudential Financial, declined to comment. Nationwide Funds Group, a unit of Nationwide Mutual Insurance, didn't return calls seeking comment.
