Closet Indexing
What is Closet Indexing?
Closet indexing is an active investment strategy in which the portfolio closely resembles that of its target benchmark. For example a global equities fund may target to outperform the performance MSCI World Index. Typically, these strategies would target to deliver a small excess return in exchange for some active risk. The source of that risk are positions in the benchmark that are not exactly matched (could be under or over weight) or are not featured in the index. However, unlike other actively managed strategies, they wouldn’t strive to deliver superior returns in excess of the benchmark through stock selection or asset allocation calls.
Key Learning Points
- Closet indexing strategies are also known as “closet trackers” or “closet constrained funds”
- They are actively managed strategies, but the composition of their portfolio closely resembles that of their target benchmark
- They could be used as an alternative to passive strategies, that seeks to enhance the return that could be achieved by an index tracking fund or an ETF
- Although the way they are managed seem more aligned with passive management, closet trackers make active decisions and that is also reflected in the fees they charge (i.e. higher than those of passive funds)
How Closet Indexing Works?
The term closet indexing is typically associated with funds that pretend to be actively managed but in reality, are not sufficiently differentiated from their target benchmark. In this case, instead of making unique stock selection decisions to outperform a market index such as the S&P 500, a portfolio manager holds a significant proportion of the portfolio in companies from that benchmark, which results in performance that is identical to that of the market index. This helps minimising the risk of substantial relative underperformance, but at the same time could be misleading to investors should they think the strategy is truly active and charges higher fees than passive funds.
The concept was popularised by Martijn Cremers and Antti Petjistö in 2006 working paper Cremers and Petajisto). They drew the line between ‘active’ and ‘closet-indexers’ at an active share of 60%. However, while this threshold is widely recognised as an industry standard, it should be noted that it only works if the underlying benchmark is well diversified. Nevertheless, funds with low active share are not inherently bad. While closet indexing is usually criticised, it may also provide a few potential benefits:
- Lower risk – closet trackers tend to offer more stable relative returns since they closely track an index.
- Diversification – closet indexing strategies typically provide broad market exposure.
- Moderate active management – depending on the approach, some closet trackers may allow some active risk to be taken in the form of selective bets on stocks with higher return potential. This typically results in small performance difference relative to the target benchmark.
Similar Approaches
Enhanced indexing is a quantitative investment approach that seeks to enhance the returns of an index (unlike passive strategies which aim to replicate it) by deciding which of its attributes are attractive and then adjust their weightings. For example, a strategy that seeks to enhance the performance of the MSCI Emerging Markets Index may adjust the weightings of its top 10 holdings in-line with the managers’ expectations, but within a pre-determined risk budget (for example the weight of each position may not differ more than 20 basis points compared to its weighting in the parent index).
Example
Below is the portfolio positioning of the Robeco QI Emerging Markets Enhanced Index Equities fund, which is an active strategy fund that aims to achieve better returns than the index through using a quantitative stock selection model.
How to Spot and Avoid Closet Indexing?
There are several measures that help investors spot a closet indexing strategy:
- Historical performance – should the long-term performance of a strategy, and especially through periods of higher volatility, is identical to that of the target index, this could be a sign of closet indexing.
- Active share – this is the ratio that shows what percentage of the portfolio’s holdings does not overlap with those represented in the underlying index. A reading of 0 would signal the strategy is a full tracker while 100 means that the portfolio is not exposed to of any of the index constituents.
- R² (r squared) – it shows what percentage of the performance of a portfolio can be explained by a change of performance in the benchmark. A higher reading may signal that the strategy’s performance is correlated to that of the target index.
- Tracking Error – this metric represents the volatility of the difference between the portfolio’s return and that of the benchmark.
The below chart shows the different styles of active management and their relation to active share and tracking error.
Drawbacks of Closet Indexing
The biggest criticism that closet indexing strategies often receive is regarding fees as investors pay higher fees without receiving significantly better returns than those of a passive index fund.
In 2020, the European Securities and Markets Authority (ESMA, the European markets regulator) conducted a research study which found that closet indexing funds had slightly lower total costs relative to their truly active peers, but nevertheless these costs were “far above those for passive funds”.
Conclusion
To sum up, closet indexing refers to actively managed investment funds which portfolio composition and performance pattern closely resemble the one of the benchmark they follow. While it still bears some positives such as providing diversification and allowing moderate active management, closet indexing products charge much higher fees than passive funds despite being managed in a similar fashion.