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Fund investing: How you can avoid the growing practice of closet indexing

by , 20 June 2014

With the pressure heavily on fund managers to perform, there appears to be a growing trend in closet indexing. Closet indexing is when an actively managed unit trust fund starts to replicate its benchmark index. The result is you're paying more for a performance you could have got from investing in a tracker fund. Let's take a closer look at what's going on and what you can do about it…

The evidence from the US shows closet indexing is on the increase

A study conducted by researchers in the US, Martijn Cremers and Antti Petajisto, developed a metric called ‘active share’ to investigate closet indexing. This metric looks at a fund’s portfolio to see how much it differs from its benchmark index.

They take 0% as the reading for a pure index fund. And take 100% for a fund that has nothing in common with the benchmark index.

The researchers took a fund measuring anything less than 60% as an indication of a closet indexer. Their results show that over the past three decades, the number of closet indexers has grown. And this may be down to the investment industry’s growing focus on short-term performance, Cris Sholton Heaton in Money Week explains.

This means investors are paying higher fees for active management that isn’t delivering.

Whilst this research is US based, it doesn’t mean that the same problem is facing the South African fund industry.

What you can do to get rid of closet indexers out of your portfolio

One sure way to eradicate closet indexers is to dump any actively managed funds from your portfolio. You can then replace them with tracker funds, which are less costly.

The other way is to try to pinpoint which of your active funds are actually doing their job and are likely to outperform at the same time. But this is no easy task. And if you don’t have the time to research this, you’d probably be better off opting for a tracker fund.

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So there you have it, how you can avoid the growing practice of closet indexing.

Fund investing: How you can avoid the growing practice of closet indexing
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