Closet Indexing
Paying for nothing
The S&P Dow Jones Indices publish a SPIVA report every year that tracks the performance of actively managed funds against their benchmarks.
The results are pretty conclusive:
Regardless of the type of fund, over a 10-year period, more than 90% of active managers underperformed their respective benchmarks. While this underperformance is relatively common knowledge, it leads to some perverse incentives among fund managers.
Reducing Career Risk by Index Hugging
Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally — John Maynard Keynes
The only way to build a portfolio that significantly beats the market is to have a portfolio that is very different from the market. If the majority of your holdings are tech stocks like Microsoft, Nvidia, and Apple, your portfolio return will not be very different than that of the Nasdaq-100.
But as a fund manager, if you build a portfolio that’s considerably different than the benchmark, it brings in the risk of massively underperforming the market. This can be detrimental to your career, and investors can leave you exactly when you need them the most.
Don’t believe us?
From Aug ’98 to Feb ’00, during the dot-com bubble, the Nasdaq was up 145%, but Berkshire Hathaway was down 44%. Here’s what Barron’s wrote in their piece “What’s Wrong, Warren?” [edited for brevity]
After more than 30 years of unrivaled investment success, Warren Buffett may be losing his magic touch.
To be blunt, Buffett, who turns 70 in 2000, is viewed by an increasing number of investors as too conservative, even passe.
Buffett, Berkshire's chairman and chief executive, may be the world's greatest investor, but he hasn't anticipated or capitalized on the boom in technology stocks in the past few years.
Buffett, being Buffett, stuck to his guns and rode out the dot-com bubble to come out on top by 2002. But this was after close to four years of underperformance, a luxury that investors and the fund house do not give to most managers.
When State Street interviewed 200 fund managers, they found that the largest determinant in the decision-making process on whether to make an investment or not was career risk.
Most investors, however, fail to beat the market — not because they aren’t as brilliant in assessing investments as Buffett is (which may also be true), but because they fear putting their careers at risk if things don’t work out as they expect. — Institutional Investor
The simplest way to de-risk your career as an investment manager would be to have holdings similar to the benchmark. That way, even if/when you underperform, the underperformance will not be drastic compared to the market. By making sure that the fund won’t deviate too far from the market, the manager gets to keep his job, even with mediocre performance.
This is called Closet Indexing or Index Hugging.
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The Curious Case of the Magellan Fund
Peter Lynch became one of the world's most famous investors by beating the S&P 500 index by an incredible 150% from 1980 to 1990 as the fund manager for Fidelity Magellan. During its peak, the fund comfortably maintained an Active Share above 80%.
But once Robert Stansky took over the fund in 1996, the Active Share fell as low as 30% and was suspected of being a closet indexer. Unsurprisingly, the fund performance suffered.
The fund [Fidelity Magellan] lagged behind the S&P 500 by about 1% per year for ten years.
This is not disastrous performance, but it is exactly what you would expect from a closet indexer: essentially the same return as the benchmark index, minus about 1% in fees and expenses for supposedly active management. — Antti Petajisto
Once Fidelity appointed Harry Lange, a bold and active manager, to replace Stansky, the active share jumped from 38% to 66% in three months.
Measuring Closet Indexing
If you invest in active funds, you buy expensive funds with the goal of beating the market. Buying expensive funds that are really closet indexers makes no sense.
Here’s how to measure closet indexing and how to make sure that the fund you are investing is not an index hugger: