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Fans of actively managed mutual funds pay handsomely to try to outperform the S&P 500. But many do not realize that some of their favorite funds resemble the S&P 500 or other index so closely that beating this benchmark by much is unlikely. When fees are factored in, the only likely result is that these active funds will underperform the index they quietly copy. "Closet index funds" is the term commonly used for these lookalikes. In many cases the astute investor could easily buy a low-cost index fund with similar returns and reinvest the savings from lower fees. Net of fees, the index fund during most years will comfortably outperform its active twin. Fidelity's Magellan Fund, the largest actively managed fund in the world, is a strong candidate for closet index fund status. Magellan has tended to follow the S&P 500 very closely, according to Morningstar. Measuring how closely an active fund follows an index is often done with a statistical measure called R-squared, a number which calculates the percentage of a fund's movement that can be mathematically "explained" by movements in the benchmark index. The higher the R-squared, the more the fund moves in parallel with the index, with 100% being the highest possible score indicating perfectly parallel movement. Some well-known active (and one index) funds currently have the following R-squared: Name Benchmark R-squared Loads Annual Fees
Source: Morningstar The table shows, for instance, that 95% of Magellan's performance can be explained by performance of the S&P 500. None of the above funds which track the S&P 500 closely would be expected to deviate significantly (for better or for worse) from the Vanguard 500 fund, but the fees are certain to be higher. Substituting an index fund for an active fund always bears opportunity risk. A small number of stocks owned heavily by the active fund but not found in such quantity in the index could rocket in value, causing the index fund to trail. This would have occurred, for instance, if a fund in past years had overweighted a star performer such as Microsoft or Cisco. Still, the sheer savings in expenses when compounded year after year gives the index investor an impressive advantage over the closet index fund investor. The following table demonstrates the increasing distance in performance over time that a closet index must cover in order to retake an index fund with lower fees. In the the first year the gap is not so great, but unless the active fund consistently outperforms it will soon fall far behind. The table assumes a $10,000 investment with annual returns net of fees of 11% for a typical no-load closet index fund and 12% for a typical index fund (whose total annual fees are 1% lower):
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