Closet Indexers’ Worst Enemy: Passive Assets

Author: Leanna Orr

Martijn Cremers

Almost nothing is more irritating for active investors than managers who claim to be playing the market but, in fact, are largely replicating it.

Happily for asset owners, the long-term tide towards passive investing in the US and other markets has helped flush some closet indexers out, according to a study.

The availability of explicitly passive products increases competition among asset managers, driving down fees and driving out index funds charging active fees, wrote authors Martijn Cremers (University of Notre Dame), Miguel Ferreira (Nova School of Business and Economics), Pedro Matos (University of Virginia), and Laura Starks (University of Texas at Austin).

The finance and business researchers examined two primary mutual fund databases—Lipper and FactSet/LionShares—covering the 2002 through 2010 period, which together provided a sample of 24,492 individual funds across 32 countries.

“We find considerable variation in the extent of closet indexing across countries,” the authors wrote. In nations “with little explicit indexing, the active funds are relatively passive.” And across the board, closet indexers tend to charge fees on par with their truly active counterparts.

Asset owners could expect fewer of these beta-in-disguise managers in markets with higher degrees of regulation, legislation pushing defined contribution retirement schemes, and those with greater concentrations of explicitly indexed capital. 

Another strategy for finding truly active managers, according to the study is: Go with the winners. “We find that fund managers who have been more successful in the past (in terms of performance and attracting flows) have higher active shares,” wrote Cremers, Ferreira, Matos, and Starks.

Assets under passive management in the study’s sample grew from roughly 14% in 2002 to 22% in 2010. According to more recent data, the trend has continued over the last five years.

But a number of active managers have—at least publically—spoken out about the positive affect this brings to their business. 

“I believe markets are inefficient, and the more assets flow to passive, the more potential alpha there will be for the rest of us,” argued John Chisholm, CIO of emerging markets specialist Acadian Asset Management, on Monday. The title of Chisholm’s position statement: “Why I Hope More Investors Move to Passive, Even Though They’re Wrong.”

Read Cremers, Ferreira, Matos, and Starks full study—“Indexing and Active Fund Management: International Evidence”—that is slated for publication in an upcoming issue of the Journal of Financial Economics.

Read this story on the Chief Investment Officer website.