The Dirty Secret Behind Closet Index Funds
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If it looks like an index, quacks like an index and charges you 2.5% in MER, it’s a closet index fund.
A closet index fund describes a mutual fund that’s a copy-cat, look-alike, mirror image, carbon copy or whatever you call it, to the underlying benchmark. Typically, these funds hold remarkably similar stocks under the hood. You’ll find little differentiations between buying a closet index fund versus a vanilla index fund, but there is one big dirty secret that fund companies won’t tell you; closet index funds charge you about 2.5% in management expense ratio for doing practically nothing. When the portfolio looks virtually identical to the market, the manager has a daunting task of consistently overcoming the 2.5% disadvantage every year. It’s in investors’ best interest to stay away from closet index funds.
Here is one example of a closet index fund. Compare the top holdings between RBC Canadian Equity and TD Canadian Index. It’s bad enough that RBC Canadian Equity fund managers imitate the TD Canadian Index fund, but the fund also trails the benchmark by 3.14%/year over the previous 15 years.
TD Canadian Index
RBC Canadian Equity (a.k.a. closet index fund)
Here are 3 methods to spot a closet index fund:
- Repeat what we just did. It’s less scientific, but looking under the hood works reasonably well. Visit www.globefund.com or www.morningstar.ca, type in the mutual fund name, and compare the top holdings with an index fund, such as the TD Canadian Index e-Fund. If they look similar, then it’s a potential closet index fund.
- Another easy way is to compare the charts between the fund and the benchmark. Here is an example of comparing RBC Canadian Equity with the benchmark, and another example with ABC Fundamental-Value . Make sure you select “S&P/TSX Total Return” from the Compare vs. Benchmark drop down.
- The advanced method is to get the R-Squared value, which reveals how much of the price movements are due to fluctuations of the underlying benchmark. It’s a number between 0 and 100; the greater the value, the closer the fund follows the index. I’m typically suspicious of R-Squared values greater than 90. Unfortunately, FundScope is the only site that I know of which offers R-Squared information, and there’s a $39.95 annual fee. If you know of a free site, please share.
Further readings on closet index funds:
- Closet Indexing by Canadian Funds Watch
- Closet Index Funds, Investors Don’t Ask, Funds Don’t Tell by Will McClatchy
- Beware of the Closet Index Fund by O’Reilly
Great post!
Another red flag might be fund size - the larger the fund, the more likely it is to resemble the index.
It amazes me that most investors are afraid to DIY because they think they will make mistakes. Meanwhile their advisor will probably put them in mainstream funds from the larger mutual fund companies and in the case of Cdn equity and probably others as well, those funds might all be pretty similar.