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.

Related posts:

1. When A Fundamental Index Will Outperform a Market Capitalization Weighted Index
2. BMO Index Mutual Funds Want To Add “ETF” To Their Official Names
3. Index Funds and the Liquidity Premium

Not all index funds are created equal. Some actually track their indices pretty well, and some do a poor job. Most people think that tracking an index would be a relatively simple thing but you know what they say, “in theory, theory and practice are the same but in practice they are not.”

Some sources of index fund tracking errors:

1. Resampling (Or Optimization)

If an index has 500 constituents, then it is impractical to replicate all the holdings when the fund has a small amount of assets. For example when an index fund first starts trading, it may only buy another manufacturer’s ETF to get market Beta until there are enough assets in the fund to actually go out and buy some or all the holdings itself. The index fund manager may also choose to hold a portion of the 500 holdings until the fund gets really big (to minimize transaction costs). How do they pick which stocks to hold and which they don’t? It’s up to them, but one method is to pick a combination of stocks that allow them to replicate the GICS sector allocations in the index (Global Industry Classification Standard). That means that if financials are 20% of the index and consumer discretionaries are 20% and so on, they will pick the combination of stocks that allow them to match those numbers – in this case they are seeking to match sector Betas.

2. Cash Flow timing

When money is added to a fund it must then be deployed into the holdings. In the case of ETFs, if not enough money is added to a fund to buy a creation unit, it might sit in cash until the next day. If the underlying stocks move between the positive cash flow and the cash deployment, this could affect the index fund’s performance. In the case of a mutual fund, the portfolio manager (yes, index funds have them too actually!) might get a small cash flow and not be able to deploy it into all the underlying constituents – they may choose to buy an ETF for market or sector beta, or buy a portion of the underlying constituents and make up the difference the next trading day when new money comes in, or if money leaves the fund for a redemption.

3. Proxies

Some index funds (with foreign exposure) may buy the foreign holdings on foreign exchanges, and some may buy ADRs or GDRs (American Depositary Receipts or Global Depositary Receipts). ADRs trade in the US but may trade at a premium or discount to the actual underlying stock.

4. Market Access

Again, index funds with foreign exposure may have stocks that trade in markets that are closed when domestic markets are open and vice-versa. If the index fund buys the direct stocks, someone has to deploy the cash overnight – it can be the fund custodian who sub-contracts out to a foreign prime broker, or the fund might have an office in that market. But if the fund operates in a different market, they can only receive the money during their hours of operation, so the underlying stocks can change in value between the time the cash comes to the fund and when it gets deployed.

If the fund buys ADRs then you still have the issue of the ADR lagging the movement of the underlying stock since money gets deployed right away, but in a security (the ADR) that can itself be moved by supply-demand issues on the market it trades even though the underlying security is not being traded. Again, this can introduce tracking error.

5. Dividend Drag

This really falls into the cash flow management arena, but instead of the cash flows being due to investors adding or subtracting money from the fund, with dividend drag it is due to the receipt of dividends earned on the underlying stocks being held. The fund receives cash which has to wait to be deployed.

6. Securities Lending Income

Same principle as with dividend drag, except the positive cash flow is due to the income generated from loaning out stocks in the fund to short sellers.

7. Brokerage commissions

The fund itself has to pay commissions to buy and sell stocks, so this will create a drag on returns too.

8. MER

Ah yes, can’t forget this one! The Management Expense Ratio is made up of the Management Fee and Operating Expenses, and of course these will drag down performance of the fund as well.

Conclusion

These are some of the areas which can introduce tracking error and I haven’t even talked about currency concerns. Different index companies tracking the same indices can have dramatically different tracking errors and its certainly something that doesn’t get enough attention. Note that some of these factors may generate positive or negative tracking errors and some (i.e. fees) can only generate negative tracking error. In its purest form, tracking error is the absolute magnitude of the deviation from the index and is not normally referred to as being positive or negative, but breaking it down this way is helpful.

Related posts:

1. Does your index fund hold direct stocks or ADRs/GDRs?
2. Index Funds and the Liquidity Premium
3. Buying ADRs to Avoid Stamp Duty

There were also some follow up questions on my original blog post, the answers to which may be of interest to other readers so I’m including it here for your reference. A reader had asked if there was any way to figure out the unrealized capital gains liability that has accrued in any one Vanguard ETF. And there is. The answer can be sourced directly from Vanguard’s website. Just click on the fund in question, then select the “Distributions” tab and you’ll find a line that says “Unrealized appreciation/depreciation”. Right below that is the amount as a percentage of the NAV. For example, for VWO (which is a share class of VEIEX, the index mutual fund) here is the link.

Related posts:

1. Vanguard ETFs have Different Tax Considerations Than Other ETFs
2. Even More Clarity on Vanguard ETF Taxation
3. Tax Advantages of Segregated Funds versus Mutual Funds