Closet Indexing: What it Means, How it Works, Drawbacks

What Is Closet Indexing?

Closet indexing is a strategy used to describe funds that claim to actively purchase investments but wind up with a portfolio not much different from the benchmark. By doing so, portfolio managers achieve returns similar to an underlying benchmark, like the S&P 500, without exactly replicating the index. The motivation for closet indexing grows out of years of poor performance and the ongoing shift from active to passive management. Flows out of active and into passive funds have topped hundreds of millions in assets under management for multiple years. This has put pressure on fund managers who fear the passive industry will eliminate stock-picking jobs. 

How Closet Indexing Works

Closet indexing might stick to an index in terms of weighting, industry sector, or geography. A manager's performance is usually compared to a benchmark index, so there is an incentive for managers to gain returns that are at least like the index. Even if the fund performs slightly worse than the benchmark net of all fees, the manager is touted for their stock-picking ability. 

Closet indexing is often viewed negatively by investors because they could simply choose an index fund and pay lower fees. On the surface, it might be difficult to identify if a fund practices closet indexing but a closer look at the prospectus can uncover a fund's true holdings. There are a few ways to spot funds that replicate a benchmark index.

Tools like R Squared and tracking error determines a portfolio's statistical deviation from the benchmark index. R Squared is by definition a statistical measure that represents the percentage a fund deviates or conforms to a benchmark. Meanwhile, tracking error depicts the difference between a fund's returns and the benchmark, otherwise known as active risk. Another metric to look at is the active share, which establishes the percentage of holdings that differ from the benchmark index. A portfolio with an active share between 20% and 60% is considered a closet indexer. 

Drawbacks of Closet Indexing

The biggest issue investors have with closet indexing is the high fees that active managers continue to charge, despite taking a passive approach. Investors wind up taking the brunt of this indiscretion because they pay higher fees for similar or mediocre performance. However, choosing a fund with a high active share won't necessarily translate to better returns. In the end, active funds that beat benchmark returns tend to have lower fees than the traditional actively managed fund.