Emerging market fund managers guilty of closet indexing

Marshall L. Stocker, Ph.D., CFA,  Global Macro Equity Portfolio Manager

Boston  - Active managers that invest in emerging markets may be "closet indexing" to avoid uncomfortable performance comparisons to passive, benchmark-based strategies.

Looking like the index limits the chance of material underperformance. However, some active managers charge high fees while merely mimicking their investment benchmark, known as closet indexing.

In our study of diversified emerging market equity mutual funds, we find substantial evidence of closet indexing behavior. The median mutual fund's country weights vary by less than 20% versus the MSCI Emerging Markets Index. Only 15% of managers achieve an active country share greater than 30%.

As country allocation decisions are the primary determinant of excess returns of emerging market funds, active country share may justify or refute the management fee charged by a purportedly active manager.

Furthermore, the probability of top quartile performance is higher for those funds with large active country share. Yet, we also find that to realize top-quartile performance, investors often must first endure periods of significant underperformance.

Bottom line:  Our study of mutual funds that invest in emerging markets revealed that some investors may be overpaying managers who simply mimic the index.