Is Your Mutual Fund a Closet Indexer?

Here's an interesting piece from SmartMoney magazine that asks if your mutual fund is a closet indexer. In other words, does the fund manager buy stocks that mirror a major index instead of holding a mix of stocks designed to beat it. Here's a summary of why such a fund would be a bad deal for investors:

[A fund manager] is supposed to spend his time picking stocks that will outperform a benchmark like the S&P 500. Shareholders pay hefty fees for those skills. But if he is at the helm of a closet index fund it means he's essentially just buying the same 500 stocks that are in the S&P index. In other words, he so closely hugs his target it will be almost impossible to beat it. Meanwhile, investors are paying three, four, and even fives times the fees of a low-cost index fund. Needless to say, investors in a closet index fund should head for the exits.

Let's see -- same return as an index fund but several times the cost? Hmmmm. Sounds like an investment disaster to me.

The article goes on to tell how to identify whether or not your fund is a closet indexer and gives some thoughts on what to do if it is.

But why bother? Why not just invest in index funds, take it easy, and earn good returns? Come on, you know you want to do it. Come on, Luke. Join me. You don't know the power of the dark side...

Ok, I'm feeling a bit playful today. But you get the point. There are so many advantages to investing in index funds, I don't know why everyone isn't into them.

For more thoughts on investing, see these posts:

• The Greatest Enemy of a Good Investment Plan

• Investment Smackdown: Are Stocks or Real Estate a Better Investment?

• Why Index Funds Deliver Such Great Returns

Comments

[Edmund]

What are your thoughts on hedge funds? I know their fees are very high compared to normal mutual funds, but is it a good way to diversify?

[CPA1298]

Hedge funds = bad idea. The S&P 500 outperformed the hedge fund index by several points last year. And, they still charged 2/20 (2% of assets, 20% of profits) for the thrill.

[Edmund]

Do you have a longer historical return than just last year?

[Duane Gran]

You might find a summary of Petajisto's research (http://www.som.yale.edu/Faculty/petajisto/20060719dresdner.pdf) to be of interest. The SmartMoney article glossed over the impact of the study, which reveals that active management is more effective than it is given credit. Funds which employ closet indexing tend to achieve lower performance.