How To Spot A Closet Indexer

Closet indexing is when a portfolio manager, more or less, mimics the benchmark index the fund is being compared with. In other words, the portfolio manager isn’t exhibiting the skill that you are paying for through management fees. Closet indexers exist, in part, due to the structure of compensation in the portfolio management world. Managers who consistently perform about average are likely to keep their jobs and receive bonuses, and it is easy to perform average if they simply mimic the benchmark index. Active managers who deviate from the benchmark index too much may end up losing their jobs if their picks aren’t successful.

So how can we tell who is a closet indexer? The most readily available statistical measure to us is R-squared. R-squared measures the degree to which the variance of one variable explains the variance in another variable. In investing, think of these two variables as the fund you are investing in and its benchmark fund - something like the S&P/TSX Composite Total Return Index. It is going to tell us the percentage of the fund’s returns which are influenced by the index.

Now, we fully expect passive funds such as ETF’s to be pretty close to a value of 100%, as the purpose of these funds is to replicate its benchmark index. These funds do not require any manager skill, which is why the management fees are so low. But with active investments, we expect to see a lower R-squared number; however, closet indexers typically are going to have higher scores.

Morningstar Canada’s Fund Screener provides a 3-year R-squared score for a lot of mutual funds. I recommend going there and searching for your fund. If you’re looking to compare managers, you can use tool to filter for Active Investment Styles and whatever other filters you’d like to apply. By clicking on the Risk tab, you can sort by 3-year R-squared values. The category average for Canadian equity funds is a 3-year R-squared score of 87.58%, for example.

If you discover that you are paying high management fees for a fund with a very high R-squared value, you may want to ask yourself what exactly you are paying for and do some more research. If you discover that the fund is underperforming its benchmark index by an amount close to the management fees you are paying, then you may be better off just investing in the benchmark index (by way of a related ETF or passive mutual fund) and saving on the fees.

It should be noted that low R-squared values should not justify higher fees. If you are paying an active manager to take above average risk, however, it does make sense that their R-squared values are lower than average. It all depends on what your risk profile looks like, and the fund’s intended investment audience should be contained in the Fund’s prospectus or the Funds Facts document.

Best of luck!