Advisors stand their ground on ‘closet indexing’

Advisors stand their ground on ‘closet indexing’

Advisors stand their ground on ‘closet indexing’ New academic research suggests that many active portfolio managers are really just closet indexers leading some in the financial services industry to cry foul but others suggest detractors might not be taking into account some built-in shortcomings of the Canadian equity markets. 
According professors Martijn Cremers of the University of Notre Dame, Miguel Ferreira of the Nova School of Business and Economics, Pedro Matos of the University of Virginia and Laura Starks of the University of Texas in the Journal of Financial Economics, 37% of the equity mutual funds sold in Canada, while supposedly utilizing active management, are actually mimicking indexe. That puts the value advisors provide clients in question.
They do have a point and it’s not necessarily a new one but before sending active managers packing it’s important to consider some of the reasons why 37% are closet indexers in Canada compared to 15% in the U.S.
Northland Wealth Management CEO Arthur Salzer believes client impatience combined with a simultaneous desire for market-beating performance puts active managers in a precarious position.
“Likely the most underappreciated risk in asset management by clients is career risk; this is the risk that a portfolio manager endures when his returns are deviating away for the broad published market indices,” Salzer told WP. “While many investment styles can and do outperform a published benchmark overtime, the patience of the average investor, consultant or even asset manager is much shorter.”

Salzer calls this is the “what have you done for me lately” syndrome; it’s very detrimental to investor well-being.

“Portfolio managers understand this as they are bombarded with it every day,” said Salzer. “To deviate too far, for too long greatly increases the risk of significant redemptions and the risk of termination by the employer (career risk).”

So, it’s fair to say that closet indexing isn’t necessarily the fault of the portfolio manager but rather fund company executives who are focused on short-term results rather than longer-term performance, not to mention collecting on those high MERs.

Another big problem with the Canadian equity market is its size. Far smaller than south of the border where you can pick 50 companies from the S&P 500 and still have an actively managed large-cap portfolio. That’s definitely harder to do with the TSX.

“They say Canada is the worst for doing it [closet indexing] but you have to remember how many companies are in the TSX Composite. Something like 238,” said Nova Scotia advisor Glen Rankin who’s with Assante Financial Management. “So, if you want banks which ones do you pick? You’ve got six to choose from. Seventy-five percent of the index [market cap] is in resources, energy and financials. You’ve got 2% or less of the companies are in healthcare. If you want healthcare you have to pick Valeant. It’s kind of difficult not to be similar to the benchmark in Canada because our market’s not broad enough.”
  • Robert Roby 2015-11-24 1:03:44 PM
    One good dividend mutual fund and one good value fund for Canada along with a few ETF:S such as health care and agriculture, coupled with individual US dividend paying stocks and a true International fund such as Mawer. Very nice portfolio.
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  • Ken 2015-11-24 4:35:18 PM
    These funds should be sold as index funds with a very low MER . Overcharging Canadians is just a form of misrepresentation and theft .
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  • Robert Roby 2015-11-25 2:29:44 PM
    Hello Ken

    If you believe that index funds are the only answer you are gravely mistaken. Theft and misrep is where one does not provide full transparency. I can recall in 2009 when the market crashed the eft side of the portfolio came down 51% and the stock fund side came down 18%. It not all about costs its about the total value you bring to the table. If that was not the case anyone can buy an eft, so perhaps you will soon be out of a job.
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