Advisors stand their ground on ‘closet indexing’

Some may be criticizing closet indexing, but advisors are defending the practice pointing to the limitations of the Canadian equities market

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.”