Shining A Light On `Closet Index Funds'

With total returns averaging 26.5% annually for the past three years, the Standard & Poor's 500-stock index has been a hands-down winner. So any mutual fund that has been able to mimic that performance should be applauded, right?

Wrong. If you're paying top dollar for an actively managed mutual fund, yet earning returns no better than those of a low-cost index fund, you could be getting a bad deal. What you actually might own is a "closet index fund." That's one with similar volatility and returns as the S&P--but with a sales charge, or "load," as high as 6.5%, plus annual expenses of $1 or more for every $100 invested. By comparison, true index funds, which automatically invest in a list of stocks in proportions that reflect the makeup of the S&P, are almost always sold "no-load," with expenses as low as 20 cents of every $100 invested. "There's nothing wrong with investing in a closet indexer as long as you pay index-like fees and not those of active management," says Ronald Peyton, president of Callan Associates, an investment management consulting firm.

REGRESSION. Closet index funds raise performance issues as well. If a fund does well mainly because it's hugging the S&P during a strong period, how is it going to perform when second- and third-tier stocks start outperforming the S&P, as they have for the past two months? You were expecting your fund manager to show stock-picking prowess. Instead, he or she delivers S&P-like returns. Except now, those numbers don't look so hot.

Pension-plan sponsors responsible for billions of dollars spend millions on consultants like Callan to keep tabs on their money managers and watch out for closet indexing. Mutual-fund investors should be on guard as well. Since S&P index funds are ubiquitous, investors should view what actively managed funds can do for them against what they can earn from the S&P. With an index fund, you can be sure of getting the index' return. So if the likelihood is that an actively managed fund is going to behave like an index fund, what's the point in investing in it? It may beat the index, but then again, with its higher costs, it may not.

To determine if your funds are closet indexers, the monthly mutual-fund returns have to be "regressed" against those of the S&P. This involves calculating the relationship between the historical price behavior of the fund and that of the index. The calculation produces a statistic known as "R2." This figure will range from 0 and 100. The higher the number, the more closely the fund tracks the index. A properly run S&P index fund should have an R2 of 100. Fortunately, you can find the regression data for many funds in two publications, Morningstar Mutual Funds and Value Line Mutual Fund Survey, and in Morningstar and Value Line mutual fund software.

To smoke out the closet indexers, we used Morningstar Principia for Mutual Funds, a software program, to search for all U.S. equity funds with three-year R2s. We then screened the funds for "beta," a measure of volatility that's pegged to the S&P. The S&P, by definition, has a beta of 1.00. We excluded funds with betas greater than 1.10 or less than 0.90, since funds much more or less volatile than that are less likely to be clones. All told, we found 508 funds. Of those, 41 had R2s of 100--and those were all index funds. But we also found a few that call themselves "enhanced" index funds that use derivatives to tweak returns or lower risk. We then tossed out funds with R2s below 95, trying to focus on those that were closest to the index.

COINCIDENCE? We came up with about 70 suspect funds. High on the list, with an R2 of 99, was GE U.S. Equity (table). "We are clearly not an index fund," says Gene Bolton, manager of domestic equities at GE Investments. Bolton says the fund is run by four managers, each with a different investment style. The portfolio's composition, Bolton adds, differs from that of the index. The fund is heavier in energy and financial stocks and lighter in utilities than the S&P. Spokespersons for MFS Massachusetts Investors Trust and State Street Research Investment also emphasized that their funds' sector-by-sector makeup is different from that of the S&P, and the high R2s are coincidental.

Perhaps so, says Charles Trczinka, a finance professor at New York University's Stern School of Business. But "if the managers are working hard and still coming up with an index-like return, maybe they need to rethink what they are doing." To investors, he says, what matters is the return--not the processes that went into it. As a practical matter, he says, "if it looks like a index-fund return to you, then it is."

Some of the S&P look-alikes resemble the index by design. "If you're somewhere around the index, you're winning the game," says John Cain, portfolio manager of Tower Capital Appreciation Fund. Like a number of funds with near-perfect correlations with the S&P, Cain is "sector neutral." He seeks to maintain the fund's sector weightings such as energy, technology, and finance in the same proportion as in the index but to add value through stock selection. So does James Miller, who runs Pacific Horizon Blue Chip: "We know the difference between a good stock and bad stock, and we choose just the good ones for the fund." The fund has the same industry makeup as the S&P, but not the same stocks. "Merck is 1.5% of the S&P, but it's over 2% in our fund, and Pfizer is 1% of the S&P, and we don't own it at all," he notes.

CODE WORDS. Indeed, managers argue that there's nothing wrong with sticking close to the index. "People don't want surprises," says Daniel Eagen of Compass Select Equity Investors. Eagen says he gives investors "a little higher return than the index after fees and expenses." The fund has done that this year and last. Goldman Sachs Core U.S. Equities has the same goal, though it has come up short of late. Portfolio manager Robert Jones says that expenses will be cut, but they still won't be anywhere near as low as those of an index fund.

So are these near-index funds trying to pull a fast one? It depends on what they tell you, says John Rekenthaler, investment strategist for John Nuveen & Co. If the fund uses code words such as "disciplined" or "sector neutral," expect it to behave like an index fund. "But if it says it will invest in blue-chip stocks, you have no reason to expect it to behave like an indexer," he says.

To be sure, statistical tools such as R2s can't prove a manager is a closet indexer. Whether a fund earns that moniker is up to the fund's investors. "You can't be sure, but if you suspect it, you can always leave the fund," says Scott Lummer, a managing director at Ibbotson Associates, an investment consulting firm. "Your loyalty is not to the fund manager but to yourself. With so many other funds out there, why take the chance of owning a closet indexer?"