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“Closet” Index Funds

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Is your actively managed stock fund hiding the fact that it actually behaves like a stock index such as the Standard & Poor’s 500 without calling itself an index fund? The reason you should care whether you have a “closet” index fund is that actively managed funds, whose managers handpick stocks, tend to charge much higher fees than index funds and generate higher tax bills because of more trading activity. Actively managed funds can justify those extra costs if they outperform their benchmark indexes or, at least, achieve similar returns with less volatility.

How to spot closet indexers: Check a measure called “R-squared” for your actively managed fund over the past decade at Morningstar.com under “Ratings & Risk.” This measures the percentage of a fund’s movements that can be explained by fluctuations in its benchmark index. If the R-squared is greater than 95%, you’re paying a premium for a fund with virtually no chance of outperforming its benchmark.

Examples of closet index funds and their 10-year annualized performance (versus 7% for the S&P 500): 

  • Northern Large Cap Core (NOLCX). R-squared: 98.95%. Performance: 6.1%. Expense ratio: 0.59%.
  • American Century Equity Growth (BEQGX). R-squared: 98.25%. Performance: 6.06%. Expense ratio: 0.67%.
  • Schwab Core Equity Fund (SWANX). R-squared: 96.77%. Performance: 6%. Expense ratio: 0.73%.

My advice: Rather than pay a high fee for indexlike performance, invest in an index fund or exchange-traded fund (ETF) that tracks the same index for as little as 0.05% in expenses. If you want to try to beat the index, look for an actively managed fund with a 10-year R-squared below 70%, long-term performance that has beaten its benchmark and a relatively low expense ratio.

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Source: Larry E. Swedroe, director of research at Buckingham Asset Management, which manages $8.5 billion in assets, St. Louis. BuckinghamAdvisor.com Date: March 1, 2017 Publication: Bottom Line Personal