Are you holding a closet-indexer?

Some funds pretend to actively manage your money, while passively tracking indexes and charging you high active fees - Salman Ahmed at Steadyhand explains what to watch out for

Ruth Saldanha 19 November, 2019 | 1:08AM

 

 

Ruth Saldanha: Today we're going to talk about closet indexing, which has been funds claim to actively manage your money, but in fact, more or less replicate the index. Why should you care? Because you might end up paying high active fees for what is essentially a passive strategy. Salman Ahmed, Portfolio Manager at Steadyhand is here with us to discuss this today.

Salman, thank you so much for being here.

Salman Ahmed: Well, thanks for having me.

Saldanha: First up, what is closet indexing? And why is it not in investors' interests?

Ahmed: Sure. We should take a step back and just differentiate between indexing and active. So, an index fund would be – the goal of an index fund would be to replicate the market. The goal of an active fund would be to do something different that might be to beat the market or have less risk than the market. That's one distinction. The second distinction between the two is their fees. Because in indexing, you're replicating, it's a little bit lower cost. So, the fees that investors would pay would be the product costs and the advice costs. That product cost would be smaller for passive or index funds compared to active funds where there might be more costs for hiring people to do the research or quantitative or compliance reasons. Closet indexing is when a fund pretends to be an active fund and by doing that it charges more. But it's actually just really replicating the index. So, it's akin to going to a restaurant, a nice Italian restaurant and being served your Chef Boyardee or canned tomato sauce without you realizing that that's what you're actually eating.

Saldanha: How common is closet indexing in Canada?

Ahmed: It's quite common. There are certain asset classes where it would be more common. So, bond funds, for example, are – it's just harder to be active in bond funds. And even in Canadian funds, Canadian equity funds, it's harder because Canada is very concentrated market. Three sectors dominate. So, it's hard to look different than the Canadian market. There's no clear stats on how prominent or how often funds are actually closet indexing. But it's quite common.

Saldanha: Are the regulators doing anything about it? And not just in Canada, but even globally, what are some of the steps that are taken to protect investors against this?

Ahmed: There's some action globally, specifically in Europe and in the States. In Europe, just this year, the Bank of Ireland, which is the Irish regulator, identified 200 funds that they said – they named them – that were that were closet indexing. The U.K. regulators, the European regulators have done the same. They found that by their assessment up to 15% of funds are closet indexing. In Canada, we haven't seen any move by the regulators to do something. Frankly, we've got other issues that need to be resolved with. We've got transparency, conflicts of interest, fees. So, there are a few things that need to be resolved in Canada before I think the regulators are able or have the capacity to look at closet indexing as a serious issue, which it is.

Saldanha: From an investor's standpoint, what should I do to protect myself?

Ahmed: There's a few things you can do. It requires a little bit of work. But it's not hard work really. Even by simply looking at the top holdings of a fund and seeing whether it compares very closely to the market or a benchmark would give you a clue. Then you can look at whether the sectors, the sector weights or the region weights in a fund align very closely with the underlying benchmark or index. That will give you another clue. And then, after that, if the returns through the history of the fund have lined up very closely with the index, less fees, then I think that is a pretty good way to assess whether you're actually – well, you've been misrepresented and well, the fund has been misrepresented and you've bought into something that has been closet indexing.

Saldanha: Thank you so much for joining us today, Salman.

Ahmed: Thanks for having me.

Saldanha: For Morningstar, I'm Ruth Saldanha.

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Ruth Saldanha

Ruth Saldanha  Ruth Saldanha is Senior Editor at Morningstar.ca