Low-cost index funds are a genuine boon.
Tracking broad or narrow sectors of the market, they are the perfect
buy-and-hold investment for busy investors. What
isn't such a good deal are mutual funds that charge
actively managed fund prices for index fund investments. These funds
range from big names with well-known managers to smaller, more
obscure funds. Their portfolios are nearly identical to that of an
index fund. Why pay more for less return—when a plain vanilla,
low-cost index fund can do the job just as well? You can identify and
avoid these closet index funds by inspecting their portfolios under a
The popular image of fund managers as swashbuckling risk-takers
simply doesn't jive with reality. Institutional
investors in charge of gigantic pension funds buy mutual funds that
track sections of the market. Managers who stray from that safe niche
could lose their asset management contracts and the fees that go with
them. With corporate bean counters and institutional investors
breathing down their necks, most fund managers can't
afford to fall too far behind the averages, resulting in big fund
complexes and obsessed managers who are trying to beat their peers
and track the indexes. Taking the risks required to beat the index by
a wide margin might not pay off, so most managers
don't take them.
For those few managers who do take risks—many of whom are
employed by smaller fund shops—their success in beating the
market sows the seeds of their own downfall. It
doesn't take long for investors obsessed with
short-term returns to jump on the bandwagon and buy shares in
successful funds. As assets grow, fund managers find it more and more
difficult to craft a market-beating portfolio. Fund firms looking out
for their investors often close such funds to new investments to
preserve the manager's style and independence, but
many fund firms won't take a step that crimps their
Owning closet index funds costs you big-time. The least expensive
index funds charge less than 0.25 percent of your assets in ongoing
expenses and carry no loads. Buy into a closet index fund that
charges the average expense ratio for an actively managed fund, and
you might pay 1 percent or even more. The Vanguard 500 Index Fund,
the nation's largest mutual fund, tracks the S&P
500 index and charges 0.18 percent of assets, which is far better
than the 1.4 percent for the average, actively managed, large-blend
fund. Translated into dollars and cents, a $10,000 investment in the
Vanguard 500 Index Fund costs $18 a year, whereas a similar
investment in an actively managed fund costs $140 per year—more
than seven times more. Hold that fund for even five years, and
you'll pay at least $610 more than the fees for the
index fund. Because costs directly reduce your bottom-line returns,
you're not earning as much as you could. Add a
front, back, or level load onto that higher expense ratio, and
you'll dig yourself into an even deeper hole.
Some investors collect funds like other people collect antiques. When
you collect four or more funds in the same investment style,
you're setting yourself up for index-like returns.
In fact, you're turning your own portfolio into a
closet index fund and paying additional fund expenses to do so. Only
buy a new fund if it is substantially different from the funds you
Using Data to Spot an Index-Hugger
Spotting an index-hugging fund manager is a snap. Pull data off the
Morningstar, Yahoo! Finance, or any other fund site, and throw it
into a spreadsheet . You
can find a fund's benchmark index either in fund
reports or in Morningstar data. When you compare your target fund to
an index fund that tracks that particular index, focus on the
following prioritized points to spot signs of index investing.
Make sure the data is from the same date so that
you're comparing apples to apples.
A fund with an R-Squared
of 90 or higher is a strong candidate for
closet index fund status. The lower the R-Squared, the lower the
correlation between the fund's performance and that
of the benchmark index.
A fund with a beta of 1.0 has
performance volatility on par with the
index. The more the beta value differs from 1.0, the less likely the
fund mirrors the index.
- Sector weightings
Fund data providers classify sectors differently, but a
fund with sector weightings close to the index is likely an
- Average annual total returns for three, five, and ten years
Few funds beat indexes over the long
term. Closet index funds might have performance close to the three-
or five-year performance of an index fund, but are likely to fall
away by ten years because of the drag of their higher expenses.
Managers with a more independent mindset are less likely to closely
track index performance. For funds that charge a sales load, compare
the load-adjusted returns to the index returns.
You won't necessarily spot a closet index fund by
its tax-adjusted average annual returns. However, closet index funds
might not be as tax-conscious as the index funds they emulate, so
check the tax-adjusted returns to make sure you
aren't getting stung by lower returns and higher
taxes. Similarly, you should evaluate the costs
you'll pay for the index fund and its copycat.
There's no point investing in a closet index fund
and paying for the privilege.
- Average P/E ratios
Values within a point of the index are suspicious.
- Average EPS
Figures within a percentage point of the index are suspicious.
You can compare either the top ten holdings or the entire
portfolio to see how many companies are the same for the fund and its
corresponding index, and look for similarities in the largest
- Company size by market-cap
As with sector weightings, a portfolio close to the index in terms of
market cap is suspicious.
- Country weightings for world or foreign funds
Indexes followed by foreign and world stock fund managers are strict
in terms of the country weightings. Funds that don't
go out of bounds are candidates for closet indexhood, while those
that venture outside their limits are likely run by more
The spreadsheet in compares the Vanguard
500 Index Fund, Mairs & Powers Growth fund, and GE U.S. Equity A
fund. Mairs & Powers clearly goes its own way, whereas GE U.S.
Equity A closely follows the index. Although the expense ratios of GE
U.S. Equity and Mairs & Powers Growth are similar, Mairs &
Powers's results blow the socks off the index, while
GE U.S. Equity outperforms the index by a smidgeon over ten years.
When you run these funds through the SEC Cost Calculator (http://www.sec.gov/investor/tools/mfcc/get-started.htm),
the results for a $10,000 investment held for ten years show what a
difference management and expenses make, as illustrated in .
Table 0. A true index fund often beats the pants off a copycat actively managed fund
Ending investment value
Vanguard 500 Index Fund
Mairs & Powers Growth Fund
GE U.S. Equity Fund
A quick scan of the language in a fund report also provides clues to
a fund's strategy. Look for words like
disciplined, which are tip-offs to a closet
index fund. Consider whether a fund's strategy is
likely to produce index-beating results. Hundreds of
funds invest in large growth companies, but how many funds invest
that much differently than a low-cost S&P 500 Index Fund?
Figure 1. By comparing mutual fund measures to an index fund, you can spot actively managed funds that mirror the index