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How To Spot A Closet Index Fund


Pop open the hood of the Putnam Voyager Fund, and the contents may look familiar. That's because its top five holdings -- Pfizer (PFE), Microsoft (MSFT), Intel (INTC), Cisco Systems (CSCO), and Johnson & Johnson (JNJ) -- are also the same top five that are in its benchmark, the Russell 1000 Growth Index. If you look at Voyager's recent returns, they're very similar to the Russell index as well. The only major difference: Voyager's performance lags after subtracting its management fees.

Voyager is, as the fund experts say, a "closet index fund." It charges relatively high fees for what is essentially a generic portfolio. This isn't much of an issue for many investors in a bull market, when returns are high. But when the market is stagnant or sagging, as it is now, it can hit your bottom line badly. Voyager's 1% annual expense ratio is below average for equity funds, but in an environment in which stocks are expected, at best, to deliver only 8% or 9% a year, the fee consumes more than 10% of your total return. A comparable index fund, iShares Russell 1000 Growth (IWF), offers similar results for one-fifth the cost.

Asset size explains in part why funds become index huggers. "As funds grow, managers have to increase their number of holdings so they don't have too much money in any one stock," says Jeremy DeGroot, director of fund research at Litman/Gregory Asset Management in Orinda, Calif. "Otherwise, they have trouble trading in and out of their positions." DeGroot thinks most funds need no more than 50 stocks to be well diversified, after which they begin behaving increasingly like an index fund. "Managers start to own stocks in which they don't have any conviction," he says. Those managers often turn to stocks that are already in the index because they are being measured against that benchmark.

This closet indexing problem comes from the way the investment management industry works. Investors, both large and small, don't usually pull their money out of mediocre mutual funds -- only the really poor performers. So once a fund company has a pile of assets, it may become risk averse, preferring to hew to the index rather than make large bets that can either pay off large for investors or cause them to take their money and run. "They're trying to stay close enough to the benchmark so they don't get fired," says Jeff Molitor, director of portfolio review at fund giant Vanguard Funds.

BENCHMARK-AWARE

The $9.5 billion Voyager Fund holds 179 stocks, and each one adds something unique to the portfolio, says Steve Oristaglio, Putnam's head of investments. "Your 85th stock pick plays an important role," he says. "It may not have the expected return of your fifth stock, but in combination with other stocks in a portfolio it produces the best risk-adjusted returns." Even if the top five stocks are the same as its benchmark, Oristaglio says the rest of the portfolio is different enough from the index, and that stocks such as Adobe Systems (ADBE), Citigroup (C), Costco Wholesale (COST), and Lexmark International (LXK) are overweighted relative to the benchmark. In addition, Oristaglio says the fund's average market capitalization and trailing price-earnings ratio differ from the Russell 1000 Growth Index. But he acknowledges Putnam managers are "benchmark-aware" and that if they deviate significantly in sector or stock weightings from their benchmark, they need to have a strong reason for doing so.

Of course, not every big fund with a lot of stocks is a closet indexer. One of the best ways to identify an index hugger is by using a statistic called R-squared (or R2), which measures the percentage of a fund's movements that can be explained by fluctuations in a benchmark index. The Vanguard 500 Index Fund (VFINX) has an R2 of 100, according to fund tracker Morningstar. (You can get those statistics at www.morningstar.com.) That means the Standard & Poor's (MHP) 500-stock index determines 100% of its price movements -- up or down. "Any fund with an R2 of 95 or above raises eyebrows as a potential index hugger," says Jeff Ptak, senior analyst at Morningstar. By this standard, Voyager's R2 of 97 in relation to the Russell 1000 Growth Index is a dead giveaway. Oristaglio says that's not proof that Voyager is a closet indexer. In fact, he argues that the R2 statistic has gone up for funds in general because investors are making fewer distinctions between stocks.

R2 can reveal important differences even in funds within the same family. Consider the $39 billion Fidelity Contrafund (FNCTX) and the $66 billion Fidelity Magellan (FMAGX) fund. Contrafund has 608 stocks in its portfolio but only an 83 R2 with the S&P MidCap 400, the benchmark it most closely tracks. By contrast, Magellan has 222 stocks and a 99 R2 with the S&P 500. Contrafund is also the better performer, having a 4.7% three-year annualized return vs. Magellan's -3.7%.

SHADOW INDEXING?

Why are the two funds so different? "When people think of Magellan, they think of Fidelity, and Fidelity is very sensitive to any bad news at the fund," says Jim Lowell, editor of the Fidelity Investor newsletter. In the mid 1990s, for instance, then Magellan manager Jeffrey Vinik, expecting the market to fall, put 20% of the fund into bonds. When the market rallied, the fund lagged -- and Vinik and Fidelity were widely criticized. So rather than risk an aggressive bet, Magellan now shadows the S&P 500, Lowell says. By contrast, investors in Contrafund expect it to zig when the market zags. After all, its name is derived from contrarian. Fidelity spokesman Vincent Loporchio denies that Magellan is intentionally tracking the index. "The fund generally holds a relatively large number of stocks that are not part of the S&P 500," he says. Maybe so, but it still behaves like the index.

Fees at Magellan are reasonable for an actively managed fund, 0.7%, so it may make sense to hold on if you already own it. But when funds charge through the nose for index-like performance, it's particularly offensive. For instance, Merrill Lynch International B (MBLIX) has a 96 R2 and a 2.8% expense ratio, making it nigh impossible to beat its benchmark, the MSCI EAFE Index, over the long term. A Merrill spokesperson denies that it's a closet indexer, citing different country and sector weightings.

If you're holding an expensive index hugger, the best advice is to sell it. Then what? You can buy a comparable index fund and save money. Or, if you can tolerate greater volatility, you can pay for a genuine actively managed fund by choosing one with a portfolio of fewer than 50 stocks. Jensen Fund, (JENSX) Marsico Focus (MFOCX), PBHG Clipper Focus (PBFOX), and Legg Mason Value Trust are good examples.

The third, and possibly the best, alternative is to combine the two strategies. Place, say, 90% of your money in index funds and the remaining 10% in more focused funds. You'll get as much active management as closet index funds provide, at a much lower cost.

By Lewis Braham


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