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  • Eric Hahn

Beware of closet indexing

If you own some mutual funds, they may be less diversified than you think, not likely to outperform their benchmark indexes and overcharging you -- thanks to closet indexing.

The benchmark for many mutual funds is the S&P 500 index, featuring 500 of America’s biggest companies. You can invest in low-cost index funds that hold its components and roughly match its performance (this is called passive investing), or in funds actively managed by financial pros who decide which securities to buy and sell, and when to do so. In exchange for their expertise, and to cover the costs of their trading, you generally pay steeper fees as you hope for bigger gains.

Here’s the problem, though: Unbeknownst to most investors, many managed mutual funds are engaging in closet indexing, with their holdings greatly overlapping with those of their benchmark indexes. Clearly, it’s problematic if you’re paying 1 percent to 2 percent per year for a managed fund when you could be paying a tenth of that for an index fund.

Making matters worse is that the closer to the index’s composition a fund gets, the less likely it is to outperform the index. In 2009, researchers Martijn Cremers and Antti Petajisto reported that managed funds with holdings most different from their benchmark indexes (those with what they dubbed high “Active Share”) were likely to significantly outperform their benchmarks.

Identifying closet indexers is not a piece of cake, but you can get a rough idea by looking at a fund’s “R-squared” number, which reflects the percentage of its performance that can be explained by its benchmark’s returns. An R-squared score of 98 percent would suggest significant overlap with the benchmark, while a lower number would reflect more independence.

You can look up a fund’s R-squared score at