<\/span><\/h2>\n\n\n\nIndex funds are specialized equity mutual\nfunds that track a benchmark index, like the FTSE or the S&P 500. The main\ndifference between index funds and other equity funds is that the objective of\nindex funds is to deliver returns at par with the index being tracked, and not\nattempt to surpass index returns like other equity funds do. Index funds are\ntraditionally low-cost funds because the composition of the funds simply ape\nthe chosen index and are passively managed funds. The expense ratio is one of\nthe lowest in the industry.<\/p>\n\n\n\n
Financial institutions and financial advisors\nare often quick to promote actively managed mutual funds as a guarantee for a\nfinancially secure future and returns that beat the market, consistently. Yet\ntime and again it has been observed that these actively managed funds have been\nunderperforming the market, i.e., delivering returns that are lesser than the\nmarket returns, over a long period. <\/p>\n\n\n\n
In fact, according to a recent S&P study\n(2020), a staggering 82% of US equity funds with active fund managers have\nfailed to beat their S&P 500 benchmarks in the past 10 years! The 15-years\nperformance is even more dismal. Regardless of a bull or bear market, this\nunderperformance seems to continue, the report said. <\/p>\n\n\n\n
In contrast, there is no such pressure in\nindex funds simply because the goal of the fund stated upfront is that it will\nreturn whatever the benchmark does. The fund manager simply picks the same\ncomposition of the index in the same weightage and then may sit back and watch\nthe fund perform at par. There is a marginal variance that occurs in returns\ncalled tracking error, which is the only variable that the fund manager needs\nto monitor occasionally and attempts to keep at the minimum.<\/p>\n\n\n\n
It therefore shouldn\u2019t come as a surprise that\ninvestors are finding favor in passive funds, and are moving away from actively\nmanaged funds in large numbers. After all, meeting market returns is logically\nbetter than underperforming the market! This influx spells trouble for active\nfunds. Actively managed funds have\ngotten so big (in size of fund) that fund managers have no option but to track\nthe market benchmarks. <\/p>\n\n\n\n
As a workaround, many fund managers have\ncreated mutual fund schemes which in reality only replicate the index, but they\npass them off as actively managed equity funds. Two motives are achieved here:\na) The fund manager is not hard-pressed to move money around within the stock\ncomposition of the fund since the results are likely to be at par with market\nreturns, and b) the higher expense ratio (what the fund charges customers as\nmanagement fees) of the active equity fund is maintained.<\/p>\n\n\n\n
The expenses on these funds are displayed four\nto five times higher than actual index funds. We shall attempt to outline ways\nin which you can identify whether or not your actively managed fund is just an\nexpensive alternative to an index fund. <\/p>\n\n\n\n
<\/span>What\nare closet index funds?<\/strong><\/span><\/h2>\n\n\n\nCloset index funds refer to the actively\nmanaged funds which just shadow an index. Considering its nature of being an\nactively managed fund, higher charges are levied – such as a higher expense\nratio, professional charges, and so on. But in reality, these funds just clone\nan index fund. <\/p>\n\n\n\n
The latest SPIVA scorecard – a comparative\nstudy of the performance of mutual funds with the benchmark index S&P 500 –\nreleased by S&P annually, has some interesting insights. It provides\nevidence for the trend that over the last 20 years, only 4% of large-cap mutual\nfunds, 10% of mid-cap mutual funds, and 6% of small-cap growth funds (actively\nmanaged equity funds) were able to outperform their benchmarks. <\/p>\n\n\n\n