Actively managed funds offer the possibility of outperforming the broader market—but they charge for that possibility. The average active fund charges 0.78% in annual fees, versus 0.18% charged by passive ones, according to Morningstar.
Some investors may wonder how actively managed their active funds are, and whether they’re getting what they are paying for. That’s because in some cases, the holdings and performance of an actively managed mutual fund can mirror that of an index, a phenomenon sometimes called “closet indexing.” This outcome runs contrary to the whole purpose of an active fund, says Tony Davidow, asset allocation strategist at the Schwab Center for Financial Research.
“There’s a role for both active and passive managers in your portfolio,” Tony says, “but you don’t want to pay active fees for passive results.”
Winners and losers
First, let’s put so-called closet indexing into context. Why would an active fund mirror a passive one, even a little?
Consider the bind that many active managers are in. During any given year, between one-half and three-quarters of active managers lag behind their benchmark indexes—a fact that hasn’t gone unnoticed by managers or investors. As a result, many active managers choose not to deviate too much from their benchmarks. As the old adage goes: If you can’t beat ’em, join ’em.
But if an active fund hews too closely to its relevant index, that may not serve your ends. Here are five questions to ask that will help you to gauge how active a fund is, and whether you’re getting the results you’re paying for.
1. What would indicate that a fund manager is a closet indexer?
There’s no single measure, but there are a couple of red flags, Tony says.
- The fund’s top holdings and weights mirror the top holdings in the index.
- The fund’s annual and long-term performances closely track the index.
2. Where do you find the top holdings of a mutual fund?
Your fund company likely sends you periodic reports that list the fund’s top holdings (typically, the top 10) and what percentage of the fund’s assets are devoted to these stocks. If you don’t have a report handy, you can look up fund holdings on the fund company’s website or on Morningstar, or you can ask your financial professional to list them in comparison to the relevant index.
Even a true closet index fund won’t mimic every holding in an index, but you should consider it a warning sign when more than half of its stocks are in the index’s top holdings.
3. What’s the potential cost of closet indexing?
The fees charged by active fund managers are typically higher than those charged by index funds, and the difference can really add up. The average actively managed fund, for instance, charges about 0.6% more than the average index fund in management fees each year to pay professionals to pick and trade stocks.
For a long-term investor, that 0.6% difference can add up to a big lost opportunity over time, as you can see in the chart below.
4. What’s the advantage of actively managed mutual funds?
A good active manager will evaluate market conditions and attempt to mitigate market risks. Index funds are limited by their benchmarks, and are unable to exploit certain market movements or opportunities the way an active manager can.
Index funds typically hold almost every stock in the relevant index, in the appropriate weights, and hold them until the index changes. They don’t avoid stocks that appear overvalued. They don’t respond to changes in the economy or market conditions.
By contrast, an active manager can identify the potential impact of a crisis (say, the Brexit vote) and choose to avoid exposure in a given region or buy at depressed levels. Thus a manager who sticks too closely to the benchmark probably won’t offer the same skill, and so may not merit the higher fees.
5. What can be learned from a fund’s performance in bad markets?
A metric called the upside/downside capture ratio allows you to measure how well a manager performs in rising and falling market conditions. Ideally, you’d find one who can manage your portfolio in falling market conditions, minimizing losses relative to the overall market.
“We believe that one of the true value-added attributes of an active manager is the potential to protect portfolios, at least somewhat, when the markets get difficult,” says Tony. “Active managers, with strong downside protection, can serve as a complement to index-based strategies.”
You can ask your financial professional about a fund’s upside/downside capture ratio, or you can look it up on Morningstar’s website.
It’s worth keeping a close eye on your investments. While it isn’t always possible to beat the market with actively managed funds, you deserve to get the results you’re paying for.
What you can do next
- Read more about the role actively managed mutual funds can play in your investment strategy.
- Take a look at this quick snapshot of the kinds of fees that come with different investments.
- Talk to a Schwab Financial Consultant about the best mix of index funds and actively managed funds. Find a branch near you.