An investor has decided to purchase an actively managed mutual fund with the hopes of being able to do better than the overall market. But sometimes actively managed funds barely qualify for the title. Sometimes managers end up buying pretty much the same stocks that are in the S&P 500. They collect a fee for active management, but really they are ‘closet indexers’. If a fund is chock full of Microsoft, GE, Pfizer, Exxon and Apple (the big stocks in the S&P 500) there is a good chance they are closet indexers. There is an easy way to find out. Go to http://finance.yahoo.com and type in the stock symbol for a mutual fund (almost all mutual funds have a 5 character stock symbol). Choose a 5 year chart of the fund. On that screen you’ll have the choice to compare it to the S&P 500. How does it compare? If it outperforms or even underperforms, at least management is doing something. But if it very closely tracks the S&P 500, it’s probably a ‘closet index’ fund. Closet indexing often happens when a manager is afraid of underperforming the market, so they’ll buy stocks to closely match the S&P 500.
Why does it matter? Because of fees. If a fund is essentially an index fund, there is no reason to pay the fees of an actively managed fund. An investor could instead choose a passively managed S&P 500 ETF and save themselves some money. If your mutual fund manager won’t come out of the closet (sorry couldn’t resist) it might be time to find one who will, or alternatively switch to a lost cost index ETF.