Hunting Closet Indexers
Hunting closet indexers is a seemingly noble pursuit; no investor should be paying high fees for empty promises. But proponents of the hunt are falling into their own traps. Over-reliance on past performance is the most prevalent of all biases and foundations of poor decisions in investing. One misguided industry practice (so-called ‘closet indexing’) is colliding and risks colluding with another (reliance on past performance).
Ex post performance results alone (e.g. tracking error) tell fund investors too little about whether a fund is a closet tracker. Yes, a closet indexer will have a low tracking error but is it sufficient to delineate that, say, ABC Fund is and XYZ Fund is not a closet indexer through the use of a hard and fast ‘over/under’ of tracking error TE< 4? Over what time period and under what market conditions? At best, a tracking error threshold is a necessary, but by no means a sufficient, condition to label a product as a closet indexer.
This thinking is rooted in an archaic approach that assumes no transparency or access to information beyond performance figures. Who is leading this hunt?
To build a robust picture, fund investors can look at the components of what may drive a manager’s future activity levels. These are the various Degree of Investment Freedom levels a manager may use in her investment and portfolio construction processes. Accounting for these (both ex-post and ex-ante) is the very crux of understanding how a manager not only has been but also may in the future be ‘truly active’.
How do we get future-minded about assessing the decision-making processes of managers? A robust way to understand a manager who purports to be active is to analyze the potential and realised use of investment flexibility.
Here is the basic outline of my thinking as it pertains to hunting closet indexers:
What fund investors need to know is not so much what the manager has done but may do or, at the extreme will do in positioning a fund with expectations for the future. Performance figures, however manipulated, do not tell us this.
To know what the manager may do in the future requires an understanding of the tools and flexibility that she has at her disposal and how she is likely to use them in varying situations. Though we cannot know with certainty, we are able to gather sufficient information to understand what the ranges of possibilities are. This should be our starting point.
Degree of Investment Freedom is the framework for understanding the underlying drivers of investment decisions and ultimately performance. It provides transparency to the decision-making levers that may drive future positioning of a fund’s portfolio and ultimately performance (near or away from an index or on an absolute basis). Overlaying an understanding of a manager’s philosophy and investment approach helps to guide investors’ expectations.
An analysis of DIF scores enables fund investors to understand and measure how and when a manager may diverge significantly from the underlying index – whatever asset class that index represents. Tracking error is just too blunt and dull a weapon.
None of this speaks to talent. Just because a manager has a high Degree of Investment Freedom score, how well she might use it is an entirely different matter. Understanding the combination and interaction of the range of freedoms and how they might be used is the role of the professional fund investor. Efficiently getting and organizing the information to perform this challenging task is the what Door is all about.
- Operations
