Unbeknownst to many investors, lots of mutual funds are pulling a fast one, grabbing more money in annual fees than they really deserve.
The problem is closet-indexing, which happens when a fund has too much in common with the S&P 500 index of 500 of America's biggest companies, or with some other index that serves as its benchmark.
Indexing is good
On the surface of it, this may actually seem like a good thing. After all, broad-market indexes have long outperformed most managed stock funds. Thus, copycat funds stand to offer returns that shouldn't be too far from average.
That would be great, if it weren't for this niggling little detail: fees. The typical managed stock mutual fund sports an expense ratio (annual fee) of 1% or more -- sometimes much more. In contrast, index funds tend to charge very low fees. For index funds, charging low fees makes a lot of sense, since managers of index funds don't have much decision-making to do -- they simply buy and hold the same securities found in the index they're tracking, in the same proportions. Some index funds charge less than 0.1% -- a tenth or less of what many active funds charge!
See who's in the closet
So given that you can pretty much collect the market's average return with an inexpensive index fund, why would you want to pay more (sometimes far more) for a managed fund that doesn't do much more than mimic the index? You wouldn't. (In addition, research by folks such as Yale's Martijn Cremers reveals that closet index funds tend to underperform their more actively managed peers.)
The problem lies in identifying the closeters. A crude way to do it is to simply eyeball a fund's top holdings, seeing how similar they are to the S&P 500's. The top 10 holdings of the Dreyfus Fund (DREVX), for example, have seven stocks in common with those of the S&P 500.
A more scientific way to do it is to look at a fund's R-squared rating at Morningstar.com. A fund with a number close to 100% is very correlated with its respective index. One with a low number has delivered a performance rather divergent from the index. The Dreyfus Fund, for example, sports an R-squared number of 98.25%, suggesting that it's a closet indexer. Another metric to look at, when you can find it, is a fund's "active share," which reflects the percentage of holdings in a fund that don't overlap with its benchmark index.
Of course, there can be exceptions to the beware-of-closeters rule. Some managed funds, while overlapping considerably with their benchmark index, still significantly outperform it and therefore are in a better position to justify their higher fees. Fidelity Contrafund, for example, has an R-squared of 94.87%, but it has significantly outperformed the S&P 500, on average, over the past five, 10, and 15 years.
A look at its recent top holdings reveals some names that would have little or no weight in an S&P 500 fund, such as Dollar Tree (Nasdaq: DLTR ) , Chipotle (NYSE: CMG ) , and priceline.com (Nasdaq: PCLN ) . Dollar Tree has been growing briskly and is expected to continue, buoyed by financially pinched consumers seeking bargains. Chipotle has been posting revenue and earnings growth of around 25%, as it looks to diversify into Asian cuisine. And priceline.com is also growing rapidly, especially its international bookings. A few great picks like these can make a big difference.
What to do
If it seems like the issue of closeted index funds is going to add a lot more work to your mutual fund due diligence, that's probably not the case. Everything still boils down to fees and performance, after all. When seeking funds, you want to minimize the fees you pay and to either match the market's return, in an index fund, or beat it, in a managed fund. If a fund is lagging its benchmark over a prolonged period, avoid it.
One way to avoid high fees is by seeking out promising low-cost exchange-traded funds (ETFs). For those who like dividend stocks, the Vanguard Dividend Appreciation ETF (NYSE: VIG ) and Vanguard High Dividend Yield Index ETF (NYSE: VYM ) both deserve consideration.
If you prefer broader stock exposure, other ETFs are worth a look. The Vanguard Total Stock Market ETF (NYSE: VTI ) includes stocks throughout the U.S. market, while Vanguard Total World Stock Market ETF (NYSE: VT ) adds in international stocks as well.
A little care in choosing your funds can really pay off.
Learn about the best dividend ETFs. And if you're looking for some great investments beyond ETFs, consider these 10 Stocks for Your Retirement Portfolio.