Outing “closet index” funds

Canada is finally investigating the issue of recommendations and sales of “closet index” funds. The same problem exists in the U.S., but don’t hold your breath expecting U.S. regulators to address the problem.

A closet index fund is also referred to as an “index hugger” due to tendency of the fund to closely track a market index, just as an index fund does. The difference between an index fund and a closet index fund is that the closet index fund typically charges fees that are often 300% or more higher than the index fund.

Fortunately, investors who are willing to take the time to go online can easily spot an overpriced closet index fund. A metric known as r-squared indicates how closely a fund tracks a relevant market index.

I use morningstar.com to gather my investment data. To get a fund’s r-squared score, click “Funds” tab, look up the fund in the search box at the top of the page, then once the fund appears, then click “Ratings and Risk.” The fund’s three year r-squared rating is under the “MPT Statistics section.

While there is no universally acceptable number for designating a mutual fund as a closet index funds, I use 90 as my r-squared threshold. That means that the closet index fund essentially provides 90 percent of the return of the relevant index, albeit at the inflated price.

Another way of looking at r-squared is to view an r-squared rating of 90 as indicating that the remaining 10 percent of the fund is left to justify the extra, or incremental, cost of the closet index fund. When you consider the recent study by Eugene Fama and Kenneth French that concluded that only the top 3 percent of active managers are able to produce returns that cover their costs, r-squared becomes an even more valuable tool for investors.

Sadly. most 401(k) plans are filled with wealth robbing closet index funds. There is simply no justification for this. Expect to see litigation to address this problem in the near future in order to protect 401(k) participants and their beneficiaries.



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