Out of the Closet

One of the complaints about high-fee mutual funds is that the larger they get, the more index-like they become. There is only so much money one can put to work and so many stocks one can own before the results begin to mimic the benchmark index that is followed. We call that closet indexing.

This Seeking Alpha article describes its best, “There are at least two reasons why a managed fund would look a lot like an index one, one of which is something called career risk. The idea here is that it is ok to be wrong if you’re wrong in the same way as everyone else. I think a good example of this was the extent to which many well known managers were overweight financial stocks five years ago. Another example would be being overweight tech stocks 12 years ago.

Another reason would be size. When a fund has many billions in AUM it becomes difficult to stray from the index because it can’t really buy small stocks, it would have to buy half the company to move the needle for the fund. ”

An investor can calculate the independence of their own mutual fund holdings by measuring the variance between the fund and the benchmark which it follows. A statistical measure called R2 (”r-squared”) notes the percentage that one independent factor plays on another dependent factor. In another words, the fabeled Fidelity Magellan Fund has an 91% R2 as compared to the S&P 500 – meaning that any change in Magellan’s performance can be explained 91% by movement in the index. Almost by definition, Magellan is a closet indexer.

Last weekend’s Barron’s notes a measure called “Active Share” in an article named, Is Your Fund Manager Active Enough? The article refers to a paper written by two colleagues at the Yale School of Management. The 2009 study found that, between 1990 and 2003, funds with active share of at least 90% — meaning that no more than 10% of their portfolios mimicked the benchmark — outperformed by 1.13 percentage points after fees. Funds with active share below 60% consistently underperformed by 1.42 percentage points a year, after accounting for fees. Note that the “average” could be skewed by large outliers. The study also found that focused funds tend to have high active share, as do funds that invest in small- and mid-sized companies. The size of the fund itself is another factor — those with more than $1 billion in assets tend to have a tougher time maintaining high active share. The 25 largest funds vary in terms of Active Share.


Being “active” should be a consideration when evaluating the fee being paid. An investor should be expected to pay a manager to beat an index or provide consistent returns, otherwise that investor should either be indexing at a lower cost, or be doing it themselves. However, being “active” alone doesn’t necessarily lead to better performance. A fund could have a high active share by having a small concentration of holdings, or even benchmarking themselves off the wrong index (a process known as style drift).

The article highlights Bruce Berkowitz, the manager of Fairholme Fund (FAIRX), which tops the list of large-company funds with the highest active share. In 2012, Berkowitz’s strategy beat 99% of his peers. Over the past three years, however, Fairholme has trailed 99% of its peers. It was down 32% in 2011. Fairholme is a highly focused fund and its slogan is “Ignore the Crowd.” Its top 10 holdings make up 86% of its assets. AIG represents 32% of the total holdings. Concentrated funds tend to rank among the highest for active share, but a focused fund isn’t necessarily an active fund. Fairholme has nearly 100% active share, and 75% of its portfolio is in financials. It’s up to the investor to decide if that is worth paying for. We are highly supportive of concentrated portfolios. Although it allows portfolios of any user-direct size, The Bloodhound System defaults to portfolios of 10 stocks. The question becomes, is it worth a 1% management fee? With no 12b-1 or administrative fees, the Fairholme Fund is on the low side for mutual funds.

According to the article, the study also confirmed what most experts already knew — that small- and mid-cap funds are less likely to resemble their benchmarks. It’s not just the sheer number of companies in small-cap indexes but the fact that small-cap indexes tend to be relatively flat, while large-cap indexes tend to be top-heavy. For this reason large-company managers who want to buy any of the biggest stocks in an index will see their active share tumble.

The asset allocation process for equities has changed considerably over the past four years, and will likely continue to change as individual investors begin to further study how managers are investing their capital. In turn, individual investors are taking a more proactive role in contrast to the fact that fund managers are taking a more passive role.

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