Colorful Closet

Closet Indexers Face More Scrutiny

Colorful Closet

The perils of active management are a constant drumbeat reverberating through markets. But it turns out at least some regulators are cracking down on another red flag for long-term investors: "closet" indexers.

These are usually large asset-management complexes that tout mutual funds where portfolios are gamed to beat markets by picking individual winners.

But a dirty little secret of the active stock picking industry is that a lot of so-called active managers aren't all that confident in their own prowess to out-guess markets. By at least one estimate by researchers, these closet index funds could represent more than $1.3 trillion of American investment assets.

Regulators in at least one state, New York, are getting more aggressive about clamping down on these types of managers.

In the latest development, 13 large mutual fund shops have agreed to start providing investors later this year with information about how closely their managers are adhering to their indexes. After an "extensive" investigation into fund disclosure policies, New York Attorney General Eric Schneiderman has announced that firm's covered under such a deal are:

  • Vanguard
  • BlackRock
  • American Funds
  • T. Rowe Price
  • USAA
  • AllianceBernstein
  • Columbia Management
  • Eaton Vance
  • Goldman Sachs
  • JP Morgan Chase
  • OppenheimerFunds
  • Nuveen
  • Dreyfus

If this list looks familiar, it might be due to the fact that many of these names can be found as part of IFA's ongoing series digging into fund family returns. Those wondering about putting their money into these active funds -- such as those from Vanguard, T. Rowe Price, Oppenheimer, JP Morgan and AllianceBernstein -- could've read these in-depth reviews to already be alerted of each family's problems in trying to beat markets over time.  

The way these fund companies covered by this latest regulatory agreement are going to let investors know how closely managers are tracking their benchmarks is by using a metric known as active shares. This is a measure set to compare in percentage terms how much of a fund's holdings overlap with those of an index.

Of course, IFA has been writing about closet indexing for years. In 2013, for example, we reviewed a study by Vanguard. Besides offering a basic primer on this calculation, it also sought to dig into whether investors could use these scores to find hints as to successful active managers.

The conclusion of such an analysis, we wrote, was that "statistically speaking, there was no significant performance difference," which indicated that active shares held "no predictive value."  

In addition, we found "no significant difference between funds that achieved active share by taking highly concentrated positions within the benchmark or by venturing into positions outside the benchmark," (i.e., through style drift).

Still, active managers keep trying to "sell the potential" of beating the market, note professors Martijn Cremers and Quinn Curtis. In a 2015 research report looking at the ill-effects of closet active managers, they estimated that more than 10% of U.S. active managers were running funds in near-lock step with their benchmarks.

Think about that figure for just a moment. Independent market researcher Cerulli Associates is projecting that active mutual fund assets will exceed $13.4 trillion in the next three years. Even assuming that a rather dated estimate of 10% can be held as a constant and hasn't risen at all, that amounts to something in the neighborhood of $1.34 trillion of investment assets being sold under what could arguably be seen as pretty shaky pretenses.