“Closet indexing” is the term used to describe the practice of portfolio managers who claim to be active managers–and charge correspondingly high fees–yet maintain holdings that replicate the structure of their benchmark indices extremely closely.

What’s wrong with this?

On the one hand, the empirical evidence is that the average active portfolio manager in the US consistently falls below the performance of his benchmark index, so indexing–even closet indexing–is a viable strategy for beating most of one’s competitors.

On the other, the justification the much higher fees active managers charge is to compensate for maintaining a research department of investment professionals and for skill in figuring out a portfolio structure that both differs from the index and provides superior performance.

The issue, then, is that the closet indexer offers the client a low-cost index product in a very expensive package.  This is socially acceptable, even desired, in some circumstances–like when a luxury car dealer charges $200 for an oil change that goes for $35 at the neighborhood Jiffy Lube.

I have some sympathy for closet indexing, although not a lot.  Unlike the luxury car dealership, where by paying six times the going rate for services the customer makes a status-building public display of having money to burn, investors of all stripes have a severe aversion to underperformance.  As one of my old bosses was fond of putting it, “The pain of undereperformance lasts long after the glow of outperformance has faded.”  Outperforming is also hard to do.  So I can see how an “active” manager can drift toward the index as a strategy.

Still, to justify collecting active management fees, one should at least make an effort.

More tomorrow.