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Don't buy index impersonators
Why pay for management if your fund mirrors its benchmark so closely? Buy an exchange-traded fund instead -- or better yet, a fund with a market-beating manager.
By Timothy Middleton
Bob Smith considers himself an average small investor just trying to be more disciplined and not chase the latest returns, as he puts it. The retired federal employee, living in Severn, Md., has been comparing funds hes interested in with indexes of the same asset class -- with eye-popping results.
Smith called up charts of Fidelity Mid-Cap Stock Fund (FMCSX) and Standard & Poor's Mid-Cap 400 Spider (MDY, news, msgs) and quickly saw that their performances were strikingly similar," he wrote to me recently. This was surprising, because the Fidelity fund is run by a manager while the Spider is an exchange-traded fund that simply copies the index it's named after.
"Do fund managers try to mimic indices, or is that just coincidental? he asked. Regardless whether it's a coincidence, he adds, Why would I pay the higher fees just to get the similar index returns?
He shouldnt and neither should you.
Active managers always insist they're adding value with their skills, and will usually insist they pay only a nodding regard to indexes. But Smith has uncovered one of the fund industrys unofficial scandals: closet indexing.
Watching the benchmark
Were certainly seeing a lot of firms becoming more benchmark-conscious, says Jeff Ptak, a senior Morningstar fund analyst. He blames this on the bear market, which punished risk, including the kind taken by adventuresome fund managers.
But closet indexing isnt new: Fidelity Magellan (FMAGX) has been doing it for years, closely tracking the S&P 500 and underperforming it by an ever-widening margin, in part because of its fees. It charges an annual expense of $76 per $10,000 invested, half the industry average. By comparison, index exchange-traded funds have expenses around $20 to $25. No wonder most funds fail to beat the market.
Fidelity has loudly denied charges of closet indexing, but this is a case where you can take a lesson from common sense: If it walks like a duck and quacks like a duck, it doesnt have to scream Aflac! for you to know what it is.
The bottom line is that performance (of index clones) is not significantly different from the benchmark, notes Lipper analyst Jeff Tjornehoj. And, like Smith, you can put any fund to the test with our charts feature in the funds section of the site.
Proof in the picture
Heres the chart that piqued Smiths curiosity.
As you can see, the lines are virtually identical, except that the Fidelity portfolio lags the exchange-traded index fund by an ever-expanding amount. If you do the same chart for three years (simply chart FMCSX and change the period to three years and add MCY), youll see that the gap has become extreme over that period, with the Fidelity fund actually losing 4% of its value in each of the three years ended July 16, while the exchanged-traded fund has grown 6% annually in the same period.
You might decide, based on this chart, that Fidelity Mid-Cap isnt really a closet indexer, because it tracks the benchmark so poorly. So I charted the fund against iShares Russell Midcap Growth Index Fund (IWP, news, msgs), the exchange-traded fund that mirrors the Russell Mid-Cap Growth Index. Voila: The fit is even more perfect, although again the Fidelity fund lags, this time by about 3.5 percentage points in each of the last three years.
The point is, this fund acts like an index fund (a poor one), regardless whether the managers are consciously doing that. In my opinion, they are.
Years ago, I was offered a job editing an investment newsletter, and when I protested I had no experience designing model portfolios, my would-be boss said, Just read all the others and do what theyre doing until you get the hang of it.
A statistical fact
Thats just my opinion, but a statistical fact exists that nails down the relationship between the performance of a fund and an index, called R-squared. An R-squared of 100 (as in 100%) means the behavior of the fund is completely explained by the movement of its underlying index; an index fund, assuming its properly run and keeps its expenses down, will have an R-squared of 100.
Fidelity Mid-Caps R-squared, compared with the Russell Mid-Cap Growth Index, is 97. Magellans R-squared with the S&P 500 is 99.
As Smith correctly reasons, theres no point in paying active management fees for index-like returns. If you want the index, buy it. If you want the benefits of active management, look for funds that beat their indexes by going their own way. Among midcap funds, one candidate is Calamos Growth A (CVGRX).
This fund is anything but an indexer. The Calamos family lands in the mid-cap category with this fund by happenstance, investing in companies of every size. But the fund behaves like a mid-cap offering, delivering Standard & Poor's Mid-Cap 400 Spider-type returns with enough extra oomph to have netted shareholders an average of 8.3% in each of the last three years, nearly two and a half points more than the exchange-traded fund.
As the chart shows, this fund is index-like only to the extent that part of its performance is due to its marketplace, which is true of any fund. When this fund departs from that baseline, however, it is to outperform the index, often by wide margins. Over time, these incremental advantages add up. Over the last 10 years, the fund has beaten the market, and other mid-cap funds, by 10 or more percentage points, for average annual gains of 22.3%.
Thats all the more remarkable considering that the funds expense ratio, of 1.31%, is more than a full percentage point higher than the 0.25% of the S&P Mid-Cap Spider. Its fee is still below the equity average, but more meaningfully it is fully earned.
An excellent diversifier
The funds R-squared against mid-caps is 86, and against big stocks only 61, meaning it makes an excellent diversifier in a portfolio heavy with big caps, as well as a truly independent mid-cap fund on its own.
A low R-squared is not a magic formula that conjures up market genius: American Heritage Growth (AHEGX) has an R-squared against the S&P 500 of 65 but is among the worst funds in the industrys history, with annualized returns since inception 10 years ago of minus 3.2%.
Rather its an interesting tool for gauging how much of a managers worth is due to his marketplace, and how much hes earned on his own. The number itself is not hard to come by -- you can find it among the data on the MSN Money fund portfolio screen -- but you will benefit most from screening funds youre interested in against likely benchmarks to find the true best fit.
Dryden Small Cap Core Equity A (PQVAX) is better than average when compared with the Russell 2000 Index ($IUX, news, msgs), a conventional small-cap benchmark. But chart it against iShares S&P SmallCap 600 (IJR, news, msgs), and the active-management contribution shrinks considerably. Its R-squared to that benchmark is 99.34, according to Lipper.
Indexing is hard to beat. Thats why mutual fund advertising -- and, often, managers salaries -- are tied to beating competing funds rather than indexes. The index usually beats most of them, so closet indexing can fuel bragging rights as well as managers Ferraris.
But you dont care about that. If you want to beat most funds, buy the index. If you want to do better still, find a manager whos come out of the index closet.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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