Rebecca Harpaz, 43, owns three franchise outlets of a major fast-food restaurant in Hamilton, Ont. Prior to 2008, she paid little attention to her investments, leaving everything to her advisor. The crisis changed that. Like many, her portfolio’s recovered; but the experience convinced her she shouldn’t be in the dark about her life savings. Rebecca recently came across studies showing a significant number of people billed as active managers are, in reality, closet indexers.

She remembers her advisor explaining the benefits of actively managed funds, and that the extra fees were worth it. At the time, she simply went along with his recommendations, so her portfolio’s loaded with such funds. Her worry: If she has closet-indexer funds, she’s paying hefty active fees for passive performance. She wants to know what her advisor’s sold her.

The problem

Rebecca tells her advisor she wants evidence her funds are truly active. But the meeting’s a disappointment: he speaks in generalities and gives toned-down versions of fund companies’ marketing pitches.

She takes another tack. She brings her portfolio to a competing firm and asks for an assessment, making it clear her top concern is identifying closet indexing.

The experts

Virginia Au

Virginia Au

vice-president and portfolio manager, Trimark Investments, Toronto

Donald K. Emond

Donald K. Emond

senior financial advisor, Assante Wealth Management, Cobourg, Ont.


Degree of difficulty

6 out of 10. The main challenge in cases like Rebecca’s is the initial transfer. If the portfolio were loaded with DSC funds or would trigger heavy capital gains, it could delay the overhaul for years. Emond says the process of rebuilding her portfolio with high-active-share funds is more straightforward.

The method

Virginia Au, vice-president and portfolio manager at Trimark Investments in Toronto, says the best metric for rooting out closet indexers is active share, developed in 2009 by then-Yale professors K. J. Martijn Cremers and Antti Petajisto.

The metric is a score expressed as a percentage. For instance, an equity fund that matches the index perfectly has an active share of 0%; a fund with a score of 72% is 72% different than its benchmark. Petajisto pegs the closet-indexer cut-off at 60%—anything lower and the fund isn’t truly active.

Au says traditional measures of active management, including turnover and tracking error, paint an incomplete picture. High turnover means the manager’s buying and selling a lot of names, but the fund doesn’t necessarily look different from the index. And this activity suggests the manager’s more trader than stock picker. The latter, says Au, requires bottom-up analysis of each stock—a lengthy process. If a lot of names move in and out, chances are the manager’s not heavily vetting them, and instead is shooting for lots of small gains on short-term calls.

Tracking error tells you the difference between the fund’s return and the benchmark. “But you’re just looking at the end result, not how it got there,” says Au. That’s important because the results could be due to luck.

Active share, she explains, takes the how into account. It analyzes each name in the fund and assigns an overall score. “If a fund manager is a stock picker, it should be a high number,” says Au. She tells advisors her scores when she meets with them.

Calculating active share is highly complex. Here’s the formula Petajisto and Cremers developed:

Active share formula

Advisors can ask fund companies to provide them with active share scores for managers.

Don Emond, senior financial advisor at Assante Wealth Management in Cobourg, Ont., says he only works with managers with active share scores, since he can’t otherwise tell if a manager’s earning his or her fees. He doesn’t consider funds with less than 75% active share.

Closet indexing is the practice of staying close to the benchmark index while claiming to be an active manager and usually also charging management fees similar to truly active managers.”

– Antti Petajisto, Financial Analysts Journal, vol. 69(4), 2013.

The solution

The competing advisor gives Rebecca the bad news: most of her funds are closet indexers. She’s livid and fires her advisor. The one who assessed her portfolio takes over.

Emond says the first step is to transfer the assets in kind. Fortunately, Rebecca has no DSC units, so there’s no need to delay redemptions to avoid penalties.

Tax is another concern. “If she had any prior losses in her capital loss reserve account,” Emond adds, “we could use them against any gains we might have to trigger, implementing the changes over multiple tax years.”

Rebecca has such an account and it covers the bulk of the gains she’ll trigger.

She understands and likes the idea of truly active funds, but Emond explains the rationale for recommending high-active-share products. Studies, including Standard & Poor’s Indices Versus Active reports, have suggested active managers consistently underperform the index after fees. Defenders of active management say closet indexers skew the data. Truly active funds, Petajisto’s 2013 study shows, consistently beat the index by 1.26% net of fees.

Emond says active funds should have three characteristics in order to justify higher fees:

  1. below-benchmark risk;
  2. low correlation to the benchmark; and
  3. returns beating benchmark ETFs by a minimum of 1% net of fees.

Additionally, he looks for funds with around 25 to 40 individual stocks. “It’s an adequate number of securities for diversification purposes, so we don’t have concentration risk in any one name; but there are few enough that we have meaningful positions.”

Building the portfolio

While Rebecca’s a high earner, she’s reinvested most of her business profits into expansions, so her portfolio is currently only $1 million. Emond says maxing out her RRSP and TFSA means roughly half her assets are in registered accounts. Rebecca plans to work another 20 years, so Emond suggests a 70% equity, 30% fixed-income split in the registered accounts. Non-registered gets an 80%/20% mix. Equities in the registered accounts are equally split between Canadian and global (including U.S.) stocks. The non-registered account, which should use corporate class for tax efficiency, would have only global equities.

“Over time, global equities have tended to outperform,” says Emond. He wants Rebecca’s exposure to approximate global proportions. “So we don’t want her to have $500,000 in the Canadian market; we want her to have something south of $100,000.”

Emond suggests actively managed funds for the fixed-income portion. For both registered and non-registered, it should be an even split between Canadian and global.

He would also include tactical exposure to index products when he expects indices to outperform over a given period.

Client acceptance


Rebecca readily accepts the solution. Her problem with her previous advisor was not that the fees were too high, but that she wasn’t getting the active management she was paying for. She plans to hold the new portfolio for five years, as that’s usually how long it takes for bottom-up value strategies to bear fruit. If it beats its benchmarks net of fees, she will continue with the high-active-share strategy. If it doesn’t, she’ll consider a more passive approach.

Dean DiSpalatro is a Toronto-based financial writer.