By Jason Zweig | Oct. 28, 2016 5:20 pm ET
Image credit: “Walk-in Closet,” Wjablow (2014), Wikimedia Commons
For the managers of these portfolios, it’s all about minimizing risk — not yours, but theirs.
How does closet indexing work?
This week, Apple was 3.4% of the total value of the S&P 500 index, Microsoft 2.5%, Exxon Mobil 1.9%, and Amazon.com and Johnson & Johnson 1.7% each. So the manager of a closet index fund who is optimistic about technology and health care but skeptical about energy might put 3.5% in Apple, 2.6% in Microsoft, 1.8% in Amazon and Johnson & Johnson, but only 1.8% in Exxon.
Because the base of assets they already hold is so huge, the fate of fund companies is tied much more closely to how the stock market behaves than to how their investors behave.
Investors withdrew $15.4 billion from U.S. stock funds in September, according to the Investment Company Institute, a trade group of fund managers. But U.S. stock funds had a total of $6.3 trillion as of the end of August, and the S&P 500, including dividends, rose 0.02% in September. On such a big base, that tiny increase in market value was more than enough to offset the $15.4 billion in withdrawals. U.S. stock funds finished September with nearly $6.31 trillion in total assets.
That dynamic creates a powerful incentive for fund managers to mimic the market. If they don’t take extra risks, their funds won’t fall much more than the market during a downturn — and will go up nearly as much during any rise. So long as the market goes up more over time than the amount of money that disgruntled investors pull out, the fund managers won’t jeopardize their own paychecks.
Fund investors, for their part, are notoriously complacent. Once people put their money in a fund, its performance has to reek like a dead animal before they will pull their investment out. One study in the 1980s found that only 28% of investors ever made a change to their retirement accounts; 401(k) savers are so prone to leave their money wherever it lands that researchers have dubbed such behavior “the flypaper effect.”
Of course, the word on the struggles of active management has gotten out, and many investors are bailing.
To keep those outflows from getting even worse, many professional investors feel they have little choice except to become closet indexers.
You might think the fund manager’s job is to beat the market.
But, in fact, the fund manager’s job is to keep his job.
Consider this simple matrix, which I’ve adapted from the investment manager Mark Kritzman:
A fund manager who is right along with most of his peers — whose portfolio resembles that of the market as a whole — will earn acceptable results with minimal risk of being deserted by investors. The upper right quadrant is the safest place for a portfolio manager to live.
One whose stock picks pay off when he goes against the crowd will stand out for high returns; but being right and alone is risky, since being proven right can take time. The upper left quadrant is a perilous place for a fund manager to inhabit.
Meanwhile, a manager who is wrong along with everybody else suffers no significant penalty; his portfolio stinks, but everyone else’s does too, so investors aren’t likely to demand their money back from him in particular. The lower right quadrant is bad for a fund’s investors, but not so bad for its manager.
Finally, a manager who is wrong and alone will stick out so badly that the flypaper effect won’t even hold anymore; investors will yank their money out. The lower left quadrant is the zone of death for fund managers.
By closet indexing, managers position themselves squarely in the right two quadrants. Making only half-hearted stock picks relative to an index, portfolio managers can ensure that they won’t ever look badly wrong relative to the market — and that investors will be less likely to pull out their money.
“There are a lot of firms out there that haven’t done anything, performance-wise, for decades, and still have $25-to-$50 billion in assets,” says John Hailer, chief executive for the Americas and Asia at Natixis Global Asset Management. “A lot of them don’t want or don’t know how to raise the bar anymore. I’m hoping capitalism kicks in a bit.”
Martijn Cremers, a finance professor at the University of Notre Dame, finds in a recent paper that as index funds become more popular, they put competitive pressure on closet-index funds to become more truly active.
“Passive seems to act as a sparring partner, making active funds better,” says Daniel Nicholas, a client portfolio manager at Harris Associates, which runs the Oakmark Funds in Chicago.
That takes time, but with luck the movement toward closet indexing will reverse — and the remaining active managers will have the courage to be truly active again.
￼Source: MoneyBeat blog, WSJ.com