Passive Overlap: Exploring Closet Indexers

October 20, 2009


This paper explores how “active” many active mutual fund managers really are. It may surprise, as well as perhaps concern, the reader to know the degree of similarity in stock allocation between many mutual funds and their benchmarks. Although there’s nothing wrong with an active manager choosing to invest at least part of his or her portfolio passively, in theory, the fee an active manager charges should reflect the unique insights and abilities of that manager.

To play devil’s advocate, taken to the extreme, someone could argue that if an active manager truly thought the best stock allocation possible for his or her fund was benchmark allocation, he or she would be using his or her skill to make the determination and should be compensated accordingly. While this argument does have some merit, an investor would be far better served in such a situation investing in the same index (at a cheaper cost) and then reinvesting with the active manager when the manager decides to “go active.” It would be difficult/impossible to do this in the real world, but at the end of the day, active managers are paid based on performance (or really outperformance), and replicating significant portions of an index and charging a higher fee is not exactly a value-add for investors.

The Active Portfolio Cost metric introduced here allows comparison of investments with varying levels of expense ratios and passive overlap. By incorporating the expense ratio into the calculation, managers can be held accountable for their degree of passive investment in an actively managed portfolio. This formula allows the user to determine the actual cost of active managers’ services and better understand the true total cost of a fund.

1 Cremers, Martijn and Antti Petajisto, “How Active Is Your Fund Manager? A New Measure that Predicts Performance” Working Paper, March 2009 (forthcoming in the Review of Financial Studies).


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