Last week we talked about the three A’s of investing: Asset allocation, Alpha Generation, and Fee Arbitrage.
Definitely the most effective of these “A’s” is Fee Arbitrage. If you can buy a new Cadillac for the price of a Chevy Lumina you would take that deal. In the investment world, if you were offered a Morningstar Five Star Fund for a fraction of the price, it’s a no brainer.
The dirty little secret in the mutual fund industry is that many funds are “Closet Indexers”.
Closet indexing is a term that is applied to funds closely mimicking their correlated index, but charging fees for active management. A good rule of thumb is to look at a fund’s five year R Squared Number. R Squared measures the correlation of a fund’s performance to the index. The higher the R Squared number, the higher the correlation. The fund’s performance is largely explained by the movement in the market. If the five year correlation average is in the high 90’s, chances are you’ve found a Closet Index Fund.
With closet indexers charging active fees, it becomes very difficult to outperform the market.
According to the Investment Company Institute’s 2015 Mutual fund Fact Book, mutual fund assets have risen 36 percent to $2.2 Trillion for the period 2009 to 2015. While a 36 percent rise in assets is commendable, fees, which should fall, only fell 12% during the period. No one is doing us any favors. When you factor in greater use of institutional and retirement class shares, fees to individual investors haven’t fallen.
Investors continue to pay active fees with expense ratios in 2014 averaging approximately 83 Basis Points, and that includes those institutional and retirement share classes which are generally unavailable to individual investors. It’s difficult if not impossible to outperform the market while “Closet Indexing” and paying full freight for the privilege.
Now back to the “showroom” where those shiny new Cadillacs are on display. Portfolio Replication becomes the” vehicle” of choice. Active Management at Index pricing. Not a bad deal. Time to trade cars!