Closet indexers must differentiate or die

Closet indexers must differentiate or die

Closet indexers must differentiate or die

When deciding between an active fund or a passive investing instrument, there’s an implied tradeoff: match the market’s overall performance at a low cost — a strategy that’s paid off over a years-long bull run — or pay more for a chance to beat it. Unfortunately for investors, so-called closet indexers are trying to have it both ways, charging active-level fees to just match the market.

But one investment expert says their time is almost over. “With the evolution of low-cost indexing via ETFs and the likely elimination of trailer commissions, the mushy middle is about to undergo a bifurcation,” said Tom Bradley, president and co-founder of SteadyHand Investments, in a column published by the Financial Post.

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“I suspect a majority of the assets will go the ETF route, as indexing has momentum behind it and is most similar to the mushy funds,” he said. “Some assets, however, will go the other way.”

Bradley explained that most closet indexers, also known as index huggers, actually started out as truly active funds. But as success inflated their assets under management, it got harder for them to deviate significantly from the index. “This is particularly true in the small Canadian market where managers are forced for liquidity reasons to own the largest stocks in the index,” he said.

Institutional-side pressures have also played a role: pension fund managers are often monitored by consultants and committees that want index-beating returns without straying too much from the index. Aside from that, Bradley said, portfolio managers that lag too far behind the index put their careers at risk.

“And finally, the emergence of the bank branch as a force in wealth management has fed the mushy middle,” he said. Aside from their sheer size — most core bank funds manage billions of dollars in assets — the Big Five have a formidable distribution network that gives allows them to offer not-so-exciting products.

As the passive-active bifurcation takes shape, Bradley believes many investors will still seek products that could beat the index over time. To compete against low-cost index funds, he said, active managers have to truly break away from the index, keep their fees under control, and better highlight their benefits — such as generally holding up better in down markets compared to index funds.

“[F]inally, active managers need to point advisers and the media toward fairer performance comparisons,” he said, explaining that the renowned SPIVA (Standard & Poor’s Indexing versus Active) survey compares mutual funds’ after-fee returns with index returns that have no costs or tracking error. “An apples-to-apples comparison would be ‘F’ series mutual funds (no trailer) and actual ETFs.”

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