C&B Notes

Another Chapter in ‘Incentives Matter’

Closet indexing is a function of the financial incentives in the money management business: keep collecting management fees by performing just well enough (i.e. just below the benchmark index) to not get fired by the client.

By abdicating to index administrators the responsibility for defining what is emerging, and by allowing such designations to dictate investment decisions, active fund managers are essentially running passive funds while charging fees as if they were managing something.

The phenomenon is pervasive.  Research by Antti Petajisto, a former New York University economist who now works for the investment firm BlackRock, shows that as of 2009, nearly a third of all the money in actively managed U.S.-focused mutual funds was run by “closet indexers,” whose investments tend to mimic the composition of a benchmark index. That adds up to about $520 billion, far surpassing the amount invested in stock index funds.

Closet indexing is great for managers, as it guarantees that their performance won’t fall too far behind the benchmarks by which they’re judged.  Unfortunately, it’s very costly for investors.

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What to do?  Laziness can’t be outlawed.  Dumping active managers in favor of index funds isn’t necessarily the solution, either. Petajisto’s research shows that, on average, managers who went to the trouble of building portfolios that differed from the benchmark indexes performed well enough to justify the fees they charged.

Hence, it’s up to investors to make sure they’re getting their money’s worth.  Funds that charge fees for nothing shouldn’t have any assets to manage. What’s amazing is that so many still do.

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