Closet index funds are funds which describe themselves as actively managed, but actually track an index closely. They have high expense ratios like an actively managed mutual fund but a portfolio similar to an index fund; the returns also resemble index fund returns. In short, closet index funds charge an investor high for the returns gained from investing in a low-cost index fund or ETF.
Over the long term, the high expense rates of closet index funds can eat up the portfolio returns; and this can affect the bottom line when the market is stagnant, moving sidewise or is bearish. Well, many closet index funds start as actively managed funds, the increase in fund assets over time makes it difficult for the fund managers to actively manage the portfolio. So, in order to achieve at least the benchmark index’s performance, the fund manager tries to copy the index in the portfolio; this creates a closet index fund.
For a regular investor it is not a good deal to invest in a closet index fund when cheaper options like index funds and ETFs are available. Investors need to consider the following aspects when investing:
- R-squared ratio – tells how much a fund is similar to an index, values close to 100 can indicate that the fund is a closet index fund.
- Fund beta – beta values close to 1.0 means that the fund is performing like the index.
- Average annual returns – comparing returns of fund and index/index fund can reveal the similarity between them.
- Portfolio holdings review – is the direct mechanism for revealing how much a funds portfolio is similar to an index.
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