Investors who find themselves stuck in closet index funds can expect lower returns, according to new research from the European Securities and Markets Authority (ESMA).
The EU securities regulator published a paper examining the phenomenon of closet indexing — purportedly active funds closely tracking a benchmark index — which finds that “investors can expect lower net returns from closet indexers than from a genuinely actively managed fund portfolio.”
The study, which is based on annual fund-level data from 2010 to 2018, also found that closet indexing is associated with slightly lower investing costs than truly active funds, but that costs are far above the level for passive funds.
“Closet indexers therefore appear to pass on to consumers only a small share of the lower economic costs of benchmark-tracking compared to active management, rather than engaging in price competition,” it said.
Apart from the cost and return implications of closet indexing, the paper also said the phenomenon is a concern for regulators as it exposes investors to different risk-return parameters than they expect, and investors may be making investment decisions based on inaccurate information.
“In addition to representing a form of misconduct in its own right, closet indexing investors make worse off ex-ante,” the paper concluded.
“Our results provide strong confirmation of the concerns of supervisors and investor advocacy groups that investors in closet indexing funds face an unjustifiably high level of costs, far in excess of those for explicitly passive funds,” it said.