Why Closet Indexers Abound

The Wall Street Journal had an excellent article today about fees and active management.  The article pointed out that many funds, although they are charging typical fees for active management, are actually indexed quite closely to their benchmark.  In essence, the investor is getting a very expensive index fund.

Why is this practice so common—and, according to the article, still a growing tendency in the fund management business?  A few reasons are mentioned, but the one that struck a chord with me was the following:

Since a manager’s performance is usually judged relative to an index, staying close to the benchmark can be a way of playing it safe, says Graham Spiers, chief investment officer at wealth manager Waypoint Advisors, Norfolk, Va. “There is a framework where if managers make a mistake or are wrong, they can lose their jobs,” says Mr. Spiers, who worked at asset-management firms for 10 years.

Managers who take more risks often have periods when they lag behind the benchmark, forcing them to preach patience and point to their long-term records as a reason for investors and employers not to lose faith. That can be harder than staying close to an index and delivering returns that don’t stand out, either positively or negatively, Mr. Spiers says.

The bold is mine.  I emphasize it because the business issue in fund management is retaining assets.  Clients are often extremely concerned when a manager’s results vary from the benchmark.  I know that we spend the bulk of our conference call time with clients discussing this very issue during periods of underperformance.  It is well-known in the money management industry that clients, in general, have itchy trigger fingers.  DALBAR data shows that the average mutual fund holding period is only about three years, not nearly long enough to make sure that results are meaningful.  So a lot of firms, I suspect, make a business decision.  They figure that if they stay close to the benchmark that they will retain clients longer, and they are willing to give up the chance of significant outperformance over time to do it.  You can call it cynical or you can call it realistic.

There’s an important tradeoff that clients don’t often consider.  If you are hugging the index, how are you going to outperform it?  The only way to outperform a benchmark over time is to deviate from the benchmark–in the positive direction–over the course of a market cycle.  So you have your choice: a truly active fund with all that it entails, or an expensive index fund. 

We’ve made the decision to run portfolios with very high active share.  Our Systematic Relative Strength portfolios are a lot different than the benchmark.  We recognize that 1) we will be stuck preaching patience at certain points in the market cycle and 2) our investors and their advisors will have to be much more sophisticated and patient than the average client.  On the other hand, there is the prospect of doing significant good for the client’s net worth over time.

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