Hiding in the Closet

Standard and Poor’s, the leading US research analysis and index provider, published the SPIVA study comparing the performance of actively managed and passive index funds. A stock market index fund reflects a weighted average of several securities, is intended to represent the stock market and track changes over time.

The results of the study showed that, over a 10 and 15-year period, the majority of active fund managers failed to equal the index that they were benchmarked against.

A few active managers, nevertheless, do consistently beat the index. Several academic papers refer to these successful managers as having ‘high active share’, meaning that their selection of securities will diverge as much as 100% from those held by the benchmark index. Where the index is diversified the successful active manager, believing that he knows better than the market, will be less diversified, more concentrated and therefore take more risk. Successful active managers, like hedge fund management, have ‘skin in the game’ – they stand to make it personally big and loose big if they make wrong bets against the market. In fact, the hedge fund industry has been decimated during the last decade.

Most fund managers are employees of a management company and are judged by their investors and their employer on performance relative to the benchmark index chosen. This is often a poor match, as management companies try to show their funds in the best light possible.

An active manager will actively try and beat a given index by selecting stocks or bonds on a different basis than the index. In order to realise a profit, the manager will buy, sell, and then purchase again. The index, however, hardly moves as it is a passive construction reflecting the overall market. In order to avoid reputational and market risk by taking bets against a given index, a manager may choose to hug the index. In this case, the manager’s portfolio will mirror that of the securities in the index. Why is this a problem for investors?

An index fund may have an annual management fee of 0.05%, as does the Vanguard S&P 500 Index Fund, giving the investor an exposure to the top 500 companies in the US. However, the active manager who is a ‘closet indexer’ may charge an annual management fee of as much as 1% for the same portfolio. He may claim active trading and thus will also need to buy and sell more, in an effort to produce a performance greater than the index – but this will incur further costs, and no better profits.

It is time, therefore, that the industry ‘outed’ closet index managers. Until they do, sensible investors should ensure that they are not paying for what they don’t get! Most long-term investors would be well advised to use low-cost index funds for the core, if not for all, of their portfolios.

Jeremy Blatch TEP
Society of Trust and Estate Practitioners Logo

This article was also published in the print edition of the Sur in English