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WITH EXPENSES continuing to fall on exchange traded funds (ETF) and passively managed mutual funds, it's hard to justify investing in an actively managed portfolio that isn't pulling its own weight. It's even harder to rationalize investing in an "active" fund that is simply mimicking an index but charging 10 times or more the expense ratio of an ETF to do it.
If your client truly wants an active manager who's striving to outperform a benchmark, a closet indexer won't fill the bill. Returns are likely to be similar to the fund's chosen benchmark, only eaten down by costs.
Yet weeding out these "closet indexers" takes some time and diligence. It's worthwhile, however, because both true active management on one side, and index funds on the other, may be a better option for your clients.
A reasonably good gauge to identify closet indexers is a fund's correlation, or "R-squared," which is available in most fund rating guides such as Bloomberg, Morningstar and Yahoo Finance. This measures how much of a fund's movement is explained by changes in the underlying index. A perfect correlation to an index is 1.00. For example, the R-squared of the Fidelity Magellan fund, an actively managed portfolio, when looked at against the S&P 500, was 91 for the most recent three-year period measured by Morningstar; it...