Closet Indexing

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I've written before about mutual funds and "window dressing." When funds report their holdings (usually quarterly), they do so based on what they own on one specific day. If they want to look like they've been holding some recent big winners, they might buy some shares just before the day on which their holdings will be reported. They might also make sure to sell any dogs before that day.

Kevin Price tackled window dressing the other day at seekingalpha.com. He noted that many managed mutual funds seem to have been quietly buying lots of broad-market exchange-traded funds (ETFs), and holding them between reporting dates. This may seem innocuous, as it does deliver market-matching returns to shareholders, but remember that actively managed mutual funds should be in the business of aiming to beat the market. Such funds also typically charge much higher fees than index funds and ETFs.

Of course, some ETFs do very well. The iShares S&P Global Telecommunications (NYSE: IXP), for example, has averaged 16% annual growth over the past five years, and holds stocks such as AT&T (NYSE: T), Verizon (NYSE: VZ), China Mobile (NYSE: CHL), and Sprint Nextel (NYSE: S). But while sector-specific funds like these can outperform the overall market, broader ETFs can't hope to do more than match their respective benchmarks.

As Bank of New York Mellon (NYSE: BK) analyst Joe Keenan put it, "It is extraordinary how many traditional long-only mutual funds hold ETFs, either to equitize their cash or to get the market return and then just layer on fees." Apparently, some funds buy ETF shares but then sell them right before they have to report their holdings to the public.

This is a good reminder that when we study mutual funds, we should be vigilant. Years ago, New York Times writer Richard Oppel suggested a method for ferreting out closet indexers: "If a fund has an R-squared of, say, 90, that means that 90% of the fund's movement can be explained by movements in the component stocks of the index." (You can find R-squared data at Morningstar.com, in the "Risk Measures" section of a fund's report.)

For help zeroing in on top-notch funds, I invite you to give our Motley Fool Champion Funds newsletter a whirl -- I've found a bunch of winners there, myself.