Find out if your fund manager is a 'closet indexer'

Are you paying your active fund manager four times more than an index fund to essentially mimic the benchmark?

It's called closet indexing. Active managers do it because they don't want to lag too far behind the herd for fear of losing their jobs or their funds have gotten so big that they can't help but track the market.

"[Active managers] underperform because of industry pressures to grow huge and hug an index," said Karl Frank, a certified financial planner and president of A&I Financial Services in Englewood, Colorado.

Closet indexing can hurt investors because active funds typically have higher fees than passive funds. Last year, the asset-weighted average expense ratio for passive funds was 0.18 percent compared with 0.78 percent for active funds, according to mutual fund researcher Morningstar.

The pressure to cling to the benchmark also has increased because funds linked to stock indexes generally have performed better than funds using stock pickers. A majority of active equity funds have underperformed their passive counterparts in nearly every category over the past 10 years. (See table below.)

There are two ways you can find out if your manager is a closet indexer — tracking error and active share.

Tracking error is the difference between a fund's performance and its benchmark's performance. That data is readily available when you look at a fund's returns online. A low tracking error suggests an active fund's manager is essentially mimicking the index. (Even passive funds have tracking error because managers can't perfectly match an index's performance.)

Active share is the percentage of a portfolio's holdings that differ from the benchmark index. A higher percentage here may mean the fund manager is trying to beat the index with his or her stock picking skill. A fund with a 100 percent active share percentage would mean that it did not have any holdings in common with its benchmark.

A website run by Martijn Cremers, a University of Notre Dame finance professor, calculates the active share of U.S. mutual funds for free.

The two metrics used together can show whether a fund manager is a closet indexer.

Research from Cremers and Antti Petajisto, a portfolio manager at hedge fund LMR Partners, found that funds with high active share percentages have outperformed their benchmarks — even after fees — while closet indexers underperformed.

How to use active share

Despite the research by Cremers and Petajisto, active share may not be a good predictor of future performance.

Funds with high active share didn't outperform their peers in a five-year period that ended in December 2015, according to an analysis from Russel Kinnel, Morningstar's director of manager research.

"Active share is a good descriptor of a fund, but not a good predictor of performance," said Kinnel, who keeps tabs on active share to see if fund managers are changing their strategies.

His findings echoed those from researchers at investment management firm AQR Capital. They concluded that "active share may not be useful for predicting outperformance, but it may well be useful for evaluating costs. Fees matter and we believe they should be in line with the active risk taken."

So if you want to pick an active fund that will beat its benchmark, fees are a better place to look than active share. Kinnel found that cheap funds are more than three times as likely to outperform than high-cost funds.