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Online Investing Hacks
By Bonnie Biafore
June 2004
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HACK
#68
Beware of the Closet Index Fund
Some actively managed mutual funds have portfolios that read like stock index funds, but their fees are higher
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Low-cost index funds are a genuine boon. Tracking broad or narrow sectors of the market, they are the perfect buy-and-hold investment for busy investors. What isn't such a good deal are mutual funds that charge actively managed fund prices for index fund investments. These funds range from big names with well-known managers to smaller, more obscure funds. Their portfolios are nearly identical to that of an index fund. Why pay more for less return—when a plain vanilla, low-cost index fund can do the job just as well? You can identify and avoid these closet index funds by inspecting their portfolios under a microscope.

The popular image of fund managers as swashbuckling risk-takers simply doesn't jive with reality. Institutional investors in charge of gigantic pension funds buy mutual funds that track sections of the market. Managers who stray from that safe niche could lose their asset management contracts and the fees that go with them. With corporate bean counters and institutional investors breathing down their necks, most fund managers can't afford to fall too far behind the averages, resulting in big fund complexes and obsessed managers who are trying to beat their peers and track the indexes. Taking the risks required to beat the index by a wide margin might not pay off, so most managers don't take them.

For those few managers who do take risks—many of whom are employed by smaller fund shops—their success in beating the market sows the seeds of their own downfall. It doesn't take long for investors obsessed with short-term returns to jump on the bandwagon and buy shares in successful funds. As assets grow, fund managers find it more and more difficult to craft a market-beating portfolio. Fund firms looking out for their investors often close such funds to new investments to preserve the manager's style and independence, but many fund firms won't take a step that crimps their own profits.

Owning closet index funds costs you big-time. The least expensive index funds charge less than 0.25 percent of your assets in ongoing expenses and carry no loads. Buy into a closet index fund that charges the average expense ratio for an actively managed fund, and you might pay 1 percent or even more. The Vanguard 500 Index Fund, the nation's largest mutual fund, tracks the S&P 500 index and charges 0.18 percent of assets, which is far better than the 1.4 percent for the average, actively managed, large-blend fund. Translated into dollars and cents, a $10,000 investment in the Vanguard 500 Index Fund costs $18 a year, whereas a similar investment in an actively managed fund costs $140 per year—more than seven times more. Hold that fund for even five years, and you'll pay at least $610 more than the fees for the index fund. Because costs directly reduce your bottom-line returns, you're not earning as much as you could. Add a front, back, or level load onto that higher expense ratio, and you'll dig yourself into an even deeper hole.

TIP

Some investors collect funds like other people collect antiques. When you collect four or more funds in the same investment style, you're setting yourself up for index-like returns. In fact, you're turning your own portfolio into a closet index fund and paying additional fund expenses to do so. Only buy a new fund if it is substantially different from the funds you already own.

Using Data to Spot an Index-Hugger

Spotting an index-hugging fund manager is a snap. Pull data off the Internet from Morningstar, Yahoo! Finance, or any other fund site, and throw it into a spreadsheet . You can find a fund's benchmark index either in fund reports or in Morningstar data. When you compare your target fund to an index fund that tracks that particular index, focus on the following prioritized points to spot signs of index investing.

TIP

Make sure the data is from the same date so that you're comparing apples to apples.

R-Squared

A fund with an R-Squared of 90 or higher is a strong candidate for closet index fund status. The lower the R-Squared, the lower the correlation between the fund's performance and that of the benchmark index.

Beta

A fund with a beta of 1.0 has performance volatility on par with the index. The more the beta value differs from 1.0, the less likely the fund mirrors the index.

Sector weightings

Fund data providers classify sectors differently, but a fund with sector weightings close to the index is likely an index-hugger.

Average annual total returns for three, five, and ten years

Few funds beat indexes over the long term. Closet index funds might have performance close to the three- or five-year performance of an index fund, but are likely to fall away by ten years because of the drag of their higher expenses. Managers with a more independent mindset are less likely to closely track index performance. For funds that charge a sales load, compare the load-adjusted returns to the index returns.

TIP

You won't necessarily spot a closet index fund by its tax-adjusted average annual returns. However, closet index funds might not be as tax-conscious as the index funds they emulate, so check the tax-adjusted returns to make sure you aren't getting stung by lower returns and higher taxes. Similarly, you should evaluate the costs you'll pay for the index fund and its copycat. There's no point investing in a closet index fund and paying for the privilege.

Average P/E ratios

Values within a point of the index are suspicious.

Average EPS

Figures within a percentage point of the index are suspicious.

Holdings

You can compare either the top ten holdings or the entire portfolio to see how many companies are the same for the fund and its corresponding index, and look for similarities in the largest holdings.

Company size by market-cap

As with sector weightings, a portfolio close to the index in terms of market cap is suspicious.

Country weightings for world or foreign funds

Indexes followed by foreign and world stock fund managers are strict in terms of the country weightings. Funds that don't go out of bounds are candidates for closet indexhood, while those that venture outside their limits are likely run by more independent-minded managers.

The spreadsheet in compares the Vanguard 500 Index Fund, Mairs & Powers Growth fund, and GE U.S. Equity A fund. Mairs & Powers clearly goes its own way, whereas GE U.S. Equity A closely follows the index. Although the expense ratios of GE U.S. Equity and Mairs & Powers Growth are similar, Mairs & Powers's results blow the socks off the index, while GE U.S. Equity outperforms the index by a smidgeon over ten years.

When you run these funds through the SEC Cost Calculator (http://www.sec.gov/investor/tools/mfcc/get-started.htm), the results for a $10,000 investment held for ten years show what a difference management and expenses make, as illustrated in .

Table 0. A true index fund often beats the pants off a copycat actively managed fund

Mutual fund

Ending investment value

Vanguard 500 Index Fund

$26,801.31

Mairs & Powers Growth Fund

$43,843.75

GE U.S. Equity Fund

$23,674.26

TIP

A quick scan of the language in a fund report also provides clues to a fund's strategy. Look for words like sector-neutral and disciplined, which are tip-offs to a closet index fund. Consider whether a fund's strategy is likely to produce index-beating results. Hundreds of funds invest in large growth companies, but how many funds invest that much differently than a low-cost S&P 500 Index Fund?

Figure 1. By comparing mutual fund measures to an index fund, you can spot actively managed funds that mirror the index

Amy Crane


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