Active Fund Due Diligence: The 3-Step Filter to Avoid ‘Closet Indexers’
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Result: Closet Indexers mathematically guarantee underperformance.
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Active Fund Due Diligence: The 3-Step Filter to Avoid “Closet Indexers”
CORE INSIGHTS
- The Scam: “Closet Indexing” is when a fund charges 1.0%+ fees but holds a portfolio 90% identical to the S&P 500. You pay for a Ferrari but get a Corolla.
- Active Share Metric: The single most important number. It measures how different the fund is from the benchmark. < 60% means it's a closet indexer.
- Downside Protection: The only reason to pay active fees is lower volatility. If a fund crashes just as hard as the market, it fails its purpose.
Most “Active” funds are frauds. They hug the index to avoid getting fired, while collecting fat fees. To find the true outliers, you must apply a rigorous Quantitative Filter that ignores marketing and focuses on structure.
The Active Share Formula
Active Share = 1/2 * Sum of |Fund Weight – Index Weight|
- 0% – 20%: Pure Index Fund
- 20% – 60%: Closet Indexer (Avoid)
- 80% – 100%: True Stock Picker
What-If Scenario: Fee Drag Effect (8% Market Return)
| Fund Type | Gross Return | Fee | Net Return |
|---|---|---|---|
| Closet Indexer | 8.0% | 1.0% | 7.0% (Underperform) |
| Vanguard VOO | 8.0% | 0.03% | 7.97% (Benchmark) |
Visualizing the Active Share Matrix
*Figure 1: The Matrix. Only funds in the Bottom-Right (High Active Share, Low Fee) are worth a look.*
Strategic Action Steps
1
Check “Active Share”
Use Morningstar Direct or ActiveShare.info. If it’s not listed, assume it’s low. Funds with high Active Share brag about it.
Use Morningstar Direct or ActiveShare.info. If it’s not listed, assume it’s low. Funds with high Active Share brag about it.
2
Analyze Capture Ratios
Look for Upside > 90% and Downside 100% (falls more than market), run away.
Look for Upside > 90% and Downside 100% (falls more than market), run away.
3
Verify “Skin in the Game”
Check the SAI. Does the manager invest >$1M of their own money in the fund? If they don’t eat their own cooking, neither should you.
Check the SAI. Does the manager invest >$1M of their own money in the fund? If they don’t eat their own cooking, neither should you.
The Bottom Line: Who Should Choose What?
- Avoid Active: 95% of investors. Stick to low-cost indexing (#120). It wins by default.
- Select Active: Only if you access top-tier managers with High Active Share and Low Fees.
Frequently Asked Questions
What is a ‘Closet Indexer’?
A mutual fund that claims to be active (high fees) but holds a portfolio 90% identical to the index. It’s a rip-off.
What is ‘Active Share’?
A metric (0-100%) measuring how different a fund is from its benchmark. High Active Share is required for outperformance.
Why does Downside Capture matter?
Outperforming in a bull market is easy (add risk). True skill is losing less in a bear market. This preserves compounding.
Disclaimer: This content is for informational purposes only. Past performance is not indicative of future results. Consult a professional.