A growing body of literature is exploring whether and when actively managed funds are worthwhile. The studies are based on the groundbreaking work of Antti Petajisto who found that active funds do beat passive indexes—if one separates the “closet index funds” that call themselves active managers.
In other words, Petajisto found that close to a third of mutual funds are active in name only but actually collect the higher fees of active funds while hugging their benchmarks such that they perform like low-cost index funds, only less well (because of the drag of their higher fees).
A further 20% of funds are officially index funds, leaving just half of retail funds as genuinely active funds. Of those, Petajisto found that the most active funds tended to generate significant alpha for investors.
Now, a new study by three finance professors seeks to locate active managers’ incentive for closet indexing.
Aron Gottesman and Matthew Morey of Pace University and Menahem Rosenberg of Touro College build on Petajisto’s findings but propose data which they argue revises the way we regard the manager’s incentive.
The researchers write:
“What is the incentive for active funds to closet index during down markets? According to Petajisto it is that underperforming the benchmark is particularly painful in a down markets when everyone is suffering losses, as opposed to an up market where the investors are still making money. Consequently a fund that underperforms in a down market will have lower net flows than a closet indexer. These losses in flows can cause the managers’ compensation to fall as it is often tied to size of the net assets of the fund, or worse, cause the manager to be fired. To avoid these consequences it is in the manager’s interest to closet index during down markets.”
But in examining 15 years of open, retail, actively managed, no-load funds from 1997 to 2011, Gottesman, Morey (left) and Rosenberg observed that shareholders did not penalize active managers in down markets. Rather, they found that shareholders direct their fund flows to high-performing funds in up markets and penalize poorly performing funds in up markets, but they tend to leave things be during down markets.
The authors write: “Thus, while we find results somewhat different from what Petajisto theorizes, it still makes sense for a manager to closet index during down markets as outperformance is not rewarded. Indeed, why work hard to beat the market in down markets when it does not matter much for subsequently [sic] flows?”
Gottesman, Morey and Rosenberg specifically offer two alternative explanations for the manager incentive to closet index.
The first is based on an insight from behavioral finance which finds that investors feel the pain of loss more acutely than the joy of gain. For that reason, they are reluctant to sell losers.
“This theory works for our results as investors do not respond in down markets to out- or underperformance with subsequent future flows,” they write.
A second rationalist explanation is that return dispersion is so great in down markets that investors attribute fund performance to luck rather than skill and consequently neither reward nor punish managers through subsequent fund flows.
In a phone interview with ThinkAdvisor, one of the study’s authors, Mathew Morey, said he preferred the behavioral explanation while leaving the matter unresolved until clarified by future research.
Asked why just 30% of funds rather than a larger proportion of the 80% of funds that are officially actively managed don’t resort to closet indexing, Morey thought integrity might have something to do with it.
“Maybe they have better corporate governance,” he said, adding that he would be interested in studying the relationship between active share (i.e., funds that vigorously seek alpha) and Morningstar’s fund stewardship ratings, which assess shareholder-friendly fund management.
Indeed, integrity is a core issue in Morey’s study, which points out that closet indexing involves deception (since the funds purport to be active); higher fees—generally 100 to 200 basis points higher than index funds; and crucially, a loss of benefit to shareholders since it is precisely during down markets that actively managed funds tend to beat their benchmarks.