Closet Indexing In The Age Of ETFs

Ian Salisbury at Marketwatch reminds us that some actively managed mutual funds may be loading up on ETFs. The preference to hold index funds in a portfolio that’s supposed to be a collection of individually chosen securities can be a warning sign that you’re paying actively managed fees for beta. Or in the parlance from the neighborhood of my youth, “You’re getting ripped off, bud.”

Sometimes the use of ETFs in an actively managed strategy is legitimate, but not always. How can you tell the difference and avoid owning what amounts to an overpriced index fund? Like everything else in the cause of intelligently choosing actively managed funds, the short answer is that you’ll have to spend a fair of time digging through the numbers and analyzing the fund through time. No wonder that a growing number of investors are opting for index funds.

That said, one example of a legitimate use of ETFs in an active strategy is tracking the target market when a surge in new investment dollars arrives. For instance, let’s say you’re running a small cap fund with $300 million in assets and suddenly $50 million of new investment drops into the portfolio. That’s a large relative increase in assets in a short time frame and the opportunities may be limited for deploying the money productively and quickly in terms of the portfolio’s mandate. Perhaps you think small-cap stocks are overvalued, for instance. Even so, you’re not going to turn down the money. What to do?

Keeping the new investments in cash is a poor choice because it will create an additional headwind for earning market-beating returns. A better option is buying a small-cap ETF as a temporary fix–emphasis on “temporary”–until more attractive opportunities emerge in individual small-cap stocks. The net result: the new capital can be deployed instantly, in a cost-efficient manner, and more or less in line with the underlying investment strategy. Meantime, you’ll avoid the dead-cash factor that will degrade performance.

The trouble here is that the use of ETFs in this way shouldn’t run on for too long. But where does one draw the line between a temporary fix and a long-term crutch? Hard to say, but just like the gray area of trying to identify pornography in advance, clear definitions are elusive but you’ll probably know the offending item when you see it. Of course, you have to be looking. Choosing high-quality active strategies doesn’t come easy, or quickly, but it’s essential if you’re going to rationalize paying the higher, perhaps substantially higher, fees relative to indexing.

The mere presence of ETFs in an actively managed portfolio isn’t necessarily a smoking gun, but it’s surely a warning sign until you learn more about the fund. Then again, some funds openly embrace ETFs as part of an actively managed beta strategy. A number of hedge-fund-like mutual funds and ETFs employ this strategy, for instance, in which case there’s nothing dishonest about the practice. Unless, of course, they’re charging exorbitant fees for owning betas and delivering risk-adjusted returns that you could easily replicate by holding a mix of ETFs that target markets across the spectrum of the major asset classes.

How can tell the difference? You can start by considering what’s available via low-cost ETFs in a forecast-free strategy framework. For instance, as I discussed earlier this week, here’s how several simple, broadly diversified asset allocation benchmarks stack up over the past 10 years:

080212a.GIF

Can you do better? Sure, although you can also do worse, and history suggests that doing worse isn’t exactly rare, as my recent analysis of actively managed asset allocation funds suggests.

It’s no surprise to learn that active managers are jumping on the beta bandwagon. But at some point you have to wonder if you’re being overcharged for a strategy that requires minimal, if any, skill. The only time that indexing is bum deal is when you’re overpaying for it. That’s easy to avoid, but only if you’re aware of it. Closet indexing has been around for decades, and it’s in no danger of extinction, as today’s Marketwatch story warns. Fortunately, there’s a simple solution: use index funds from the start.

This post was originally published at The Capital Spectator and is reproduced here with permission.