Are You Paying a Premium for "Pretend" Active Management?

A recent study by Professor Derek Horstmeyer (1) and his research team has uncovered a concerning trend in the mutual fund industry: many actively managed funds are essentially engaging in "closet indexing." This means they are closely hugging their benchmarks, mimicking their performance, while still charging higher fees than passive index funds.

The Illusion of Active Management

Horstmeyer's analysis of decades of mutual fund data revealed that, with the exception of small-cap funds, active managers are increasingly imitating their benchmarks. They are not making the bold, differentiated investment decisions that investors expect from active management.

Why This Matters

Investors pay a premium for active management with the expectation that skilled managers will generate returns that outperform the market. However, if these managers are essentially replicating index funds, those higher fees become harder to justify.

The Downside of "Closet Indexing"

There are several significant drawbacks to closet indexing for investors:

1. Higher Costs: Active funds typically charge higher fees than passive index funds. If you're not getting true active management, you're essentially overpaying for a product you could get at a lower cost.

2. Underperformance: After accounting for fees, closet indexing funds may underperform their benchmarks and lower-cost index funds. This defeats the purpose of paying a premium for active management.

3. Lack of Transparency: Closet indexing funds often lack transparency about their investment process and how actively they manage their portfolios. This makes it difficult for investors to evaluate whether they are getting true value for their money.

What to Look For

To avoid falling victim to closet indexing, investors should look for the following qualities in actively managed funds:

1. True Active Management: Seek out funds with a clear investment philosophy and a demonstrated track record of deviating from benchmarks when necessary to pursue opportunities.

2. Transparency: Demand transparency from fund managers about their investment process and how actively they manage their portfolios.

3. Cost-Consciousness: Evaluate the fees charged by active funds and consider whether the potential for outperformance justifies the cost.

By carefully evaluating actively managed funds based on these criteria, investors can increase their chances of finding genuine active management that can potentially deliver superior returns over the long term.

(1) Derek Horstmeyer, "Why You May Be Overpaying for That Actively Managed Mutual Fund," The Wall Street Journal, October 31, 2024