Almost $250 Billion Invested in Closet Index Funds in Canada

Who would’ve thought that almost 40% of mutual fund assets in Canada were indexed? Definitely not the people selling them since these are all supposedly actively managed funds. (The Investment Funds Institute of Canada reports that as of April 2010, mutual fund assets in Canada are $620.4 billion.)

What Is A Closet Index Fund?

A closet index fund is a term given to an actively managed fund that looks so similar to the benchmark you’re left wondering why you are paying the higher costs of active management for it. If the fund’s holding looks really similar to the benchmark index, this is a closet index fund. One way of trying to sort through the thousands of funds available to screen for closet index funds is to look at the R-Squared rating. This is also known as the coefficient of determination and ranges from 0 to +1. The closer to +1 it is, the more closely it looks like it’s benchmark index. (Note: a high r-squared does not necessarily indicate a closet index fund, but it does mean the fund warrants a closer look.)

1,290 Mutual Funds Worth Over $245 Billion Qualify as Potential Closet Index Funds

I went over to FundLibrary.com and did a simple “Fund Filter” query and looked for all mutual funds that had an R-Squared value of 0.9 or higher. I came up with 1,290 funds with a total of $245,343,380,000 in assets amongst them. The asset-weighted MER on these funds was 1.98%. That works out to almost $5 billion in Management Expenses. Assuming the going rate for advice is 1.00%, then if advisors switched investors out of these potential closet index funds and into actual index tracking funds you might find a portfolio MER closer to 1.35% (not all funds are domestic mandates, remember). This would yield a savings of over $1.5 billion annually to Canadian investors. Wow.

YMMV (Your Mileage May Vary)

Your cut-off for a closet index fund may be higher/lower than 0.9. Further, more analysis is needed to determine if the funds are closet index funds. It IS possible that a fund with a high r-squared is not a closet index fund.

Not all funds on this list (i.e. the pooled funds) included advisor trailer fees which means the weighted average MER would’ve been higher on an apples-to-apples basis.

Clearly you could save even more by not using an advisor, but that is a different story for a different time and for the record, I think the vast majority of investors need an advisor of some sort (…a good advisor – which again is another can of worms altogether).

Do not blindly sell your funds if they have a high R-Squared rating – do your due diligence, or speak with a qualified financial professional for more guidance. Just providing food for thought here.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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Showing 8 comments
  • Weighhouseblog

    Perhaps they should rename the active-passive debate as the passive-slightly-less-passive debate.

  • The Passive Income Earner

    I have been moving away form mutual funds for a while now. It made sense to buy mutual funds when I did not have much money to invest but investing in solid blue chip companies can be easier than looking for a great fund (like a needle in a haystack). That way, you wash your hands of all the games the money manager are playing … If I need something similar to a fund, I look for an ETF these days.

    All the best.

  • Jordan Clark

    According to Investopedia http://www.investopedia.com/terms/r/r-squared.asp if a fund has a high R-Squared you should also compare the Beta, because I assume you could be getting index like returns with possibly lower then index risk, meaning it actually is better… right?

  • Preet

    Excellent question Jordan (as usual). If a fund has a high r-squared, it is possible that all the other metrics are different so it's not a catch-all condition for a closet index fund. I'll follow up on this post next week…

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