Passive Overlap: Exploring Closet Indexers

October 20, 2009

Note in Figure 1 that the optimal combination for an investor (the lower left box, shaded green) is Low Expense & Low Overlap. With this combination, an investor looking to invest in active management is getting the greatest possible value. Contrast this with the two boxes shaded yellow: Low Expense & High Overlap (upper left) and High Expense & Low Overlap (lower right). Low Expense & High Overlap would be similar to an enhanced index strategy or active manager that only deviated slightly from the target benchmark allocation. This would be a portfolio manager only seeking to add incremental alpha, but he or she is charging a lower fee in response to his or her strategy. High Expense & Low Overlap is clearly less optimal than Low Expense & Low Overlap due to the higher fee, but high-quality (i.e., alpha-generating) active management commands a fee, and if an active manager is truly delivering alpha, he or she will likely command a premium for his or her services. The remaining red, or suboptimal combination, is High Expense & High Overlap: This would be a manager known as a “closet indexer,” charging an active management fee for a passive investing strategy. This is the combination to most beware of and is the type of investment this paper most hopes to shed light on.

Passive Overlap Exploring Closet Indexers

Methodology

To determine how similar mutual funds are to their benchmarks, an analysis was conducted. All investments categorized in one of the nine domestic equity categories based on a Dec. 31, 2008 Morningstar data feed were included in this study. Note, though, since holdings data is often delayed for mutual funds, holdings data is used based on its effective date from both Dec. 31, 2008 and March 31, 2009 data feeds. Index funds, enhanced index funds and ETFs were removed from the test sample.

Passive overlap was determined by comparing the holdings of the mutual fund (or ETF) to the comparable Russell iShares ETF in the same Morningstar category (e.g., the holdings for Large Blend fund would be compared to the holdings for the iShares Russell 1000 Index Fund). This methodology differs from the methodology employed by Cremers and Petajisto, who compute active share by comparing the mutual fund holdings to 19 different indexes (a group that includes Russell, S&P and Wilshire benchmarks), and determining the active share based on the index with the highest overlap. The author’s reliance on the Morningstar style categories to select a single index allows for a more “apples to apples” comparison.

The actual ETFs, as well as the number of holdings as of Dec. 31, 2008, are included in Figure 2.

Passive Overlap Exploring Closet Indexers

Note that the initial overlap tests were also conducted against S&P, MSCI and Wilshire benchmarks, but the results (correlations) among the tests were similar (high) enough that overlap benchmark was reduced to the Russell indexes for simplicity purposes.

Information on the amount of passive overlap by investment category for the respective Russell benchmark is included in Figure 3. In Figure 3, a fund in the 95th percentile would have more passive overlap than all but 5 percent of the funds studied; a fund in the 75th percentile would have more passive overlap than all but 25 percent of the funds studied, etc.

Passive Overlap Exploring Closet Indexers

 

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