Document MF#128

August, 2003

The main reason investors take a chance on a actively managed fund, with its higher costs, is the hope of consistently beating the benchmark index by a meaningful margin. Closet indexing pretty well forecloses that possibility. A Closet Index fund is a fund that basically buys what’s in a benchmark index but portrays itself as an actively managed fund. Closet indexers do not replicate the market exactly, but stick fairly close to the market weightings by industry sector, by country or region, or by average market capitalization. Closet indexing may not be intentional. Fees can range as high as 3.0 percent versus an index fund with an MER < 0.2 percent. While this may well be a case of false/ misleading advertising and disclosure, no litigation or regulatory actions have been taken. Several Canadian equity funds have assets in excess of $2 billion, so Canadian unitholders are getting ripped off but the fund companies are racking in tens of millions of dollars in unearned excess fees. Apparently, greed has no limits, ethics or shame.

Closet indexing flourished in the 1990s bull market when the S&P 500 climbed more than 20 per cent a year for five straight years. But when everyone’s making double digit returns it’s not a front and center issue. Nowadays, you hear more talk about it. Lousy relative performance - against an index - makes more of an impression when all the absolute performance numbers begin with a minus sign and you lose even more money than the index.

Active management -- the practice of fund managers picking securities in a valorous attempt to beat the market as measured by an index -- is practiced almost universally by Canada''s broker-sold "load" mutual fund companies. The big brand-name fund factories or “independent “ advisers rarely offer index products. Many academic and other studies have conclusively shown that in the long run, only a small minority of actively-managed funds beat the index. Professor George Athanassakos of Wilfred Laurier University studied Canadian mutual fund performance between 1985 and 1996 and concluded “ Our results demonstrate the absence of any consistent stock-picking or market-timing abilities by the managers of the majority of Canadian mutual funds. Moreover, past performance is not found to have any predictive value about a fund’s future performance ”. Closet indexers are of course the worst of the lot because they don’t even offer the hope of a superior return, charge unduly high fees and mask their activity.

An index is a proxy for an economy or a sector of the economy that is provided on a daily basis by several firms like S&P, Dow Jones, Morgan Stanley and Scotia Securities. Beating an index effectively means picking those few companies that are perceived to be doing better than the economy overall. Note also that indexes are costless, frictionless and carry no cash. Indexes also exhibit survivorship bias due to the deletion of weak companies, bankruptcies and corporate mergers. Indexes are idealized constructs. And the only appropriate version of an index to benchmark is the Total Return version (includes all dividends) since fund returns always assume automatic reinvestment of distributions. Such dividends account for over 40% of the long term returns of the S&P 500. Therefore, an index is not a cinch to beat by any mutual fund over the long haul.

Passive management or indexing refers to investment practices which merely seek to mirror the returns of major stock indices, such as the S&P500 or S&P/TSX Composite. Most of Canada''s bank no-load groups sell both active and "index" funds. Barclays Global Investors Canada. (www.iunits.com) specializes in the manufacture and sale of exchange-traded index funds (ETIFs). Many additional ETF’s are available in U.S. markets. The iunit funds provide a wide range of Canadian and international indexing options. If a discount broker is used you can make sizable purchases for less than $30.00 and without all the rules, deferred sales charges and administration of a traditional mutual fund.

Exactly what is "closet indexing"?

This refers to the process of discretely (i.e. without publicity) imitating the market index, in order to achieve nearly similar results. A fund portfolio manager practicing closet indexing in 2000 might have reasoned: I don''t care if Nortel is outrageously over-valued. Because it carries a 35% weight in the TSE 300 Index, I should buy a large position in it for protection. If it keeps going up, I''ll report above average results. If it goes down, I''ll suffer like everybody else. In either case, I won’t be judged severely". Ironically, because mutual funds are limited to a 10 % holding in any one security, many equity mutual funds, including closet indexers actually beat the benchmark when Nortel imploded.

Knowing that they are measured against a market benchmark (like the S&P/TSX Composite), many fund portfolio managers are tempted by closet indexing because it allows them to report results similar to that benchmark’s. This is their “bogey” (a Scottish word meaning "goblin," and few advisers regard it in kinder terms). They keep similar holdings & sector weightings as the index, albeit with slight variations in order not to abandon any hope of beating it. Since bonuses and stock options are based on comparison with an index, it should not be surprising that behaviour follows the management dictum “What gets rewarded, gets done”.

Not all that appears to be closet indexing is intentional. If the managers are working hard and still coming up with an index-like return, maybe they need to rethink what they are doing. To investors, what really matters is the return--not the processes that went into it. As a practical matter, if it looks, feels and sounds like an index-fund return to you, then it is.

What’s wrong with closet indexing?

If what you''re looking for is simply average returns, a closet indexer may achieve that for you. But closet indexing is not a fair practice because it makes an investor pay for something that is not provided, i.e. active portfolio management. If your objective is to imitate the index, you might as well invest in an index fund or a ultra-low MER, tax-efficient Exchange Traded Index Fund. It’s far better and cheaper than an actively- managed mutual fund that practices closet indexing. The discrepancy between a fund’s formal classification and its actual asset composition can also impair attempts to create a tailored portfolio as regards content, risk and returns.

Granted, fund managers'' results are best understood relative to the conditions under which they were achieved. If a fund is down 20 per cent when the market is down 40 %, that''s cause for applause, not censure. But if the manager cares only about relative performance, the point of the whole exercise gets lost. This behaviour is easy to understand from the managers'' point of view: They want to keep their well-paying jobs. It''s not much good for investors, however, if it produces a half-baked combination of index-fund-like returns with higher managed-fund MER’s. Investors don''t need to pay active managers to bring them returns that approximate index results. ETIF’s/Index funds serve that purpose just fine.

According to a recent report by Morningstar Canada, the average MER is 2.62% (up from 2.02 % in 1995) to April 30,2003 for mutual funds sold in Canada. That''s more than 15 times! -- higher than the 0.17% charged by the Barclays i60s ETIF (TSX: XIU). This fund gives investors exposure to the top 60 Canadian stocks. ETIF’s also offer the ability to sell at any time of day and place stop- loss limit orders. You can even sell covered call options for extra income or risk management. Since portfolio turnover is negligible compared to the 100 % + figure of mutual funds, after-tax returns are better.

Critics argue that closet indexers provide "negative value added -- not just high fees, that would be bad enough, but below-market returns on top of that.

How do I tell if a fund engages in closet indexing?

There are several indicators that you can review:

1-Statement of objectives: To check any managed stock fund for "closet-indexing" tendencies first inform yourself about how a given fund aims for the best possible return by studying the fund''s description of its own objectives, the statements of its managers in Annual Reports, Prospectuses and elsewhere, and evaluations by independent research firms. If the fund uses code words such as ''''disciplined'''' or ''''sector neutral,'''' expect it to behave like an index fund.

2- Size: when funds become very large, they find it increasingly difficult to identify good differentiating investments. What is the no-brainer way to deploy the cash received each month? By putting it in highly liquid companies well represented in the index (i.e. Trans Canada Pipe, BCE, Sun Life, banks, etc.). A Dec. 2002 OSC Exemption order now allows Fund factories to own shares in their parent company, so expect virtually all bank owned funds and Investors Group to act accordingly.

3-Portfolio holdings: look at the sector representation in the portfolio as well as the fund''s top holdings. If these mimic that of the index, you should suspect the presence of closet indexing. If the fund corresponds closely to the index in terms of returns, volatility and capitalization than closet indexing is likely present.

4-R-Squared: R-Squared is a statistical indicator measuring the funds coefficient of correlation with the relevant market index. R-squared is expressed in percentage terms; with 100 percent factor reflecting perfect correlation with the index, e.g. index funds would have a near hundred percent R- squared. An R-Squared of 97% or more means, in statistical terms, that 97% or more of the fund''s results are explained by similar movements in the index, leaving little credit to the portfolio manager for his “professional ” management. This statistic is not however proof of a cause and effect relationship. R- squared may help investors determine if a fund is actively managed or whether it is engaged in closet indexing. A Low R- squared is an indication of active portfolio management, whereas a high R- squared, say greater than 95 percent, should raise suspicions of closet indexing and its consequent adverse effect on unitholder returns. If you subscribe to www.fundscope.com or similar service, you can find the fund''s with the highest (or lowest) R-Squared in each category. Otherwise, try asking the Fund Company.

“About Active Management: If your objective is to beat the index, you should go for an actively managed fund that shows little similarity with that index. To prove our point, we compared the results of actively managed funds (with an R-squared of less than 70%) to those of closet indexers and / or core and explore funds (with an R-squared of 70% or higher). The table below shows the results of this exercise for the five-year period ending August 31, 2000 (i.e. at the peak of the last bull market) vs. August 31, 2001 (i.e. deep into the bear market). In both cases, we found that the group of actively managed funds had a much higher percentage (approximately double) of funds that out-performed the Index. As a matter of fact, we did that same exercise for different time intervals and came up with the same conclusion: if you chose an actively managed fund, say with an R-squared factor of less than 70%, you almost double your chances of beating the index.” See table below:

5 -Graphical Analysis: Go to www.globefund.com and use the graphing function to compare fund performance to an index .If the 2 curves hug each other you’ve probably got an indexer. In any event, you should consider an index fund or ETIF and boost your long-term, pre and post –tax returns.

How does “reversion to the mean” relate to closet indexing?

Reversion to the mean is the tendency of investment manager performance to revert to the mean performance over time. The following material from www.fundscope.com succinctly makes a case for indexing:

“It is a pretty safe bet that you would never have considered investing in the five worst-ranked funds back in 1996. After all, that contradicts everything that most of us have been taught about going with winners. But guess what? Had you followed through on that seemingly foolish idea, you would have earned nearly 11% each year, or more than double what you would have made by going with the top-ranked performers.

This is no fluke. More often than not, the results have been similar for different performance measures, over varying periods. The table shown above looks at the ten years between 1989 and 1999. Note how the top performing funds during the first five years became, on average, the worst performers in the subsequent five years. The table shown here is entirely consistent with other findings into how mutual funds tend to perform over time. These studies indicate that high-flying funds tend to drift down to earth, while lagging funds usually pick up their performance. The experts call this pattern “reversion to the mean.”

Why yesterday’s winners often become today’s losers is a complex issue. One theory goes like this: in “efficient ” stock markets like those in the US, Canada and most other developed nations, skilled fund managers are constantly competing against each other and searching for any available scrap of information that might give them an advantage. When these fund managers do learn something, they instantly buy or sell. As a result, share prices reflect all the pertinent information available. No particular investor or portfolio manager has an information advantage over the rest of the market that would enable her or him to consistently outperform the market. ” Thus, the argument for even non-closet index funds is not an easy one to make.

At the height of the bubble, many on Bay Street lost sight of the most powerful force in investing - reversion to the mean - simply because the index comparisons looked fine. Once you set up fund managers'' incentives as index comparisons, their interests diverge from those of the investors, whose fortunes rise and fall with absolute performance. Try paying a mortgage or a university tuition bill with a note that says "I beat the S&P 500 by 40 basis points but my fund lost money”.

How does closet indexing come about?

Suppose you manage an equity fund for a boss who gauges your results against the Standard & Poor''s 500 Index benchmark. You want to try to beat the index by at least a little bit. You may have an even stronger incentive, though, to avoid falling significantly short of the index by missing the ride on a stock that winds up as one of the big winners among its components. Managers who look bad against their benchmarks are too easy to terminate.

So, to protect your butt, you set up your holdings closely in line with the index''s make-up, while valiantly angling to eke out some extra returns. Sometimes the strategy is pursued openly under a banner such as "managed index" or "index plus". Marketed this way, it has appeal for some institutional customers who themselves are held accountable to the standard of an index.

More often than not, it is done more clandestinely and without disclosure. For example, let''s say your fund came through 2002 with a return of minus 22 %, or a mere three-hundredths of a percentage point worse than the S&P Index''s 21.97 per cent loss. That''s good enough to stay employed. Your annual performance review can note that the "raw" performance, before the management fee and other costs, actually beat the benchmark.

It is vitally important to recognize how a portfolio manager is rewarded (under existing mutual fund securities legislation, disclosure is not required in the Prospectus or Annual Report) and how this may lead to closet indexing and increased risks for the fund. A table from The Great Mutual Fund Trap succinctly illustrates the point:

Some portfolio managers are rewarded not only on fund performance but also if they can keep you invested anyway through exceptional marketing and public appearances. Publicly- traded fund factories even throw in stock option incentives for portfolio managers that relate to the share price of their stock rather than exclusively to their personal contribution for creating unitholder wealth. Canadian mutual fund regulations do not require fund governance boards but investor advocates feel that closet indexing is so embedded that it won’t disappear any time soon even when such investor protection boards are established.

How big an issue is closet indexing?

Closets indexing does not appear to be a major issue with investors, the industry or regulators. Partially because holdings, sector representation and cash levels do vary at least slightly, proving deliberate closet at indexing would be difficult. Canadian equity funds especially have a limited market to choose from so that as fund size grows they tend to converge naturally on the index. In fact, bigger issues for the industry and investors are high fees, fees independents of economies of scale, poor fund governance and chronic sub- benchmark performance whether closet indexing or not.

Why look at index funds and ETIF’s?

The sheer savings in expenses when compounded year after year gives the index investor an impressive advantage over the closet index fund investor. The following table demonstrates the increasing distance in performance over time that a closet index must cover in order to retake an index fund with lower fees. In the first year, the gap is not so great, but unless the active fund consistently outperforms it will soon fall far behind. The table assumes a $10,000 investment with annual returns net of fees of 11% for a typical no-load closet index fund and 12% for a typical index fund (whose total annual fees are 1% lower):

While the actively managed fund can always retake its index kin, the above table demonstrates that as time goes on this becomes an increasingly difficult task. After 10 years, the gap needed to regain the lead is equal to 7.8% of assets. Such a task would be virtually impossible if the closet fund tracked the index closely. And remember, we used an actively managed fund differential of only 1%, a rare occurrence in the Canadian market. A front-end load fund (or a higher MER DSC fund) coupled with less tax-efficiency only makes the gap harder to bridge.

Why do investors buy closet index funds?

The basic reason is ignorance A financially illiterate investor may not be aware that ETIF’s or index funds exist. Certainly the marketing machines of the big fund factories aren''t going to point them out. Complacency and laziness could be another factor. You phone your financial adviser or walk into your bank branch and place an order. Sweet and simple. With an ETIF, you''ve got to open a brokerage account and do your own research. Hope and greed can play a role too-with an ETIF there’s no chance of beating the index; with a mutual fund there’s always a chance. Perhaps ETIF’s are too boring and lack the excitement of their active counterparts.

Another important factor is the advisory distribution system in Canada. Advisers earn lucrative fees including ongoing trailer fees by selling high- MER actively managed mutual funds, not by selling low commission index funds. Advisers are married to careers selling high-fee funds sold with deferred sales charges (DSC), or the equivalent in "wrap" accounts. They continue to believe (or profess to believe) that high-fee active funds can consistently beat the indices or that it''s possible to identify in advance the 10% or so of active managers who may have the odd streak of prolonged outperformance. They also continue to downplay or ignore the adverse tax consequences of holding active funds outside registered tax-deferred plans.

Recently, some fee-based advisers are buying lower MER index funds for clients, but the extra fees entirely negate the savings.

How are the fund Factories responding?

One major trend in the post-bubble market is that fund companies have an inclination to play it safe. We may be entering an era where the name of the game for many funds is taking on just enough risk to edge into Quartile 1 or 2 but not enough to significantly distinguish themselves from the pack. Hugging the benchmark may become the norm. Clandestinely embracing indexing could very well be the next move by the industry.

CI (formerly Spectrum Investments) started the response with its Tactonics Fund, which holds various ETFs. Spectrum reaps the cost savings of the ETFs but charges a 2.51 % MER in line with its traditional active funds. Spectrum won the Innovation award the year the product was introduced.

The CI TACTONICS Fund uses a proprietary quantitative model to select investments in any market or industry. The fund invests primarily in exchange-traded funds (ETFs) and/or other equity securities and instruments which provide exposure to those markets and industry sectors. The ETFs are traded on major exchanges and qualify as index participation units. This fund''s objective is to achieve superior long-term capital growth through the tactical allocation of assets among various markets and industry sectors throughout the world. This load fund has total assets of $59.25Million. It’s benchmark is MSCI World (Cdn $) which it has beaten, although it has negative cumulative results over 3 years. It has a Beta of 0.95. This fund doesn’t need to pay an active stock-picker, save for some managers who decide what ETFs the fund should hold and when.

Despite historical arguments like "you get what you pay for”, it turns out that actively- managed fund companies are thoroughly familiar with the power of indexing and the threat it poses to the industry. Several in-house wraps include index funds often comprising up to 35% of the total portfolio and more. The commitment to indexing by pro active- manager Assante''s U.S. division practices is surprising. Two of three of Assante American “portfolio management services" aimed at wealthy U.S. investors are 100% in index products.

Synervest Asset Management and Synervest Portfolio Services are aimed at those with more than US$100,000. They are 100% indexed by Santa Monica, Calif.-based Dimensional Fund Advisors (DFA). (See www.dfaus.com). Assante Private Client, a service for clients with US$1-million, is 22% indexed via DFA. (Source: Chevreau,“Active managers are closet indexers”)

Proponents argue that such funds are not merely index funds tracking benchmarks. They use sophisticated and innovative passive investment strategies developed by leading academics based on enhanced indexing models. Marketing literature suggests that these portfolios add value through trading, tax management and certain filters. Like actively managed funds, Advisory fees, portfolio management fees and other expenses likely cancel out any "value add" benefit. Caveat Emptor!

Other initiatives include a plethora of new hedge funds using ETIF’s and derivatives, multi-manager wraps run by wunderkind active managers and mutual funds managing a portfolio of ETF income trusts. All generate handsome fees to replace those lost to the billions in redemptions since the bear market began in late 2000.

The Canadian fund marketing machine is world class. Clever indexing products like TACTONIC will soon be on shelves. The big fund companies which once looked down on indexing see a market and that’s what counts. It turns out apparently, that Indexing in the right hands, might not be so bad after all. Be alert. Trojan horses are not limited to Greek mythology.

Some observers have noted that mutual fund managers judge their performance exclusively in relative terms-vs. a benchmark index or peer group of similar funds. If the index is down 13%, they’re heroes if they’re only down 11%. That’s phooey to most ordinary investors, who want to see their wealth expand in absolute terms and not simply get poorer slower than their neighbors. Some critics have suggested that a minimum 5-year return benchmark should be twice the long-term bond rate. In a sense, Closet indexing is in effect the by-product of an industry that has forgotten why people invest- to make money.

Closet indexing is a despicable practice that abuses investors, particularly small investors, seniors, retirees and the financially illiterate. They pay a high price for mediocre returns or even losses. One industry cynic has suggested that investors buy an ETIF and spend $104.00 each year for weekly Super 7 lottery tickets to regain the lost excitement of professional active management.

Statistical tools such as R2 can’t definitively prove a manager is a deliberate closet indexer. Whether a fund earns that moniker is up to the fund''s investors. You can''t be sure, but if you suspect it or you’re obtaining index-like risk-adjusted returns, you can always leave the fund. Your loyalty is not to the fund manager or adviser but to yourself. With thousands of other funds available & other alternative investments, there’s no need or rationale to own a closet indexer fund (intentional or inadvertent) to meet your financial objectives.

The stock market miseries of the past 3 years will have a redeeming purpose if they discourage "closet indexing ” but this appears unlikely. Money managers need to stop buying stocks and start owning companies again. There’s simply too much fixation on near-term results. As one fund manager said “ For me, long term is next quarter”.

In a world where indexing and quantitative strategies will become increasingly pervasive—and fully competitive—the successful traditional investment manager must serve the client''s interest . . . first, last, solely. The mutual fund industry must be challenged to serve its clients much more effectively.

The best defence against closet indexing is getting educated, doing your homework and looking at lower cost alternatives. Don’t expect proposed fund governance regulations to provide protection.

Ken Kivenko P.Eng.

Investor Advocate

kenkiv@sympatico.ca

DISCLAIMER

Information contained herein is obtained from sources believed to be reliable, but the accuracy is not guaranteed. The material does not constitute a recommendation to buy, hold or sell. The purpose of this Document and others in the series is to educate investors by bringing together personal finance information from a variety of sources. It is not intended to provide legal, investment, accounting or tax advice and should not be relied upon in that regard. If legal, tax or investment advice or other professional assistance is needed, the services of a competent professional should be obtained.

Abboud Suzanne, “Out of the Closet “, MoneySense, Jan., 2002

Athanassakos, G., Carayannopoulos P., and Racine R. “Mutual fund Performance: The Canadian Experience Between 1985 and 1996”, The Mutual Group Financial Services Research Centre, Wifred Laurier University, 1997 (contact gathanas@wlu.ca)

Atkinson, Howard, ”The New Investment Frontier ”, Insomniac Press, ISBN 1-894663-14-4, 2001 (excellent text on ETF funds)

Baer G. and Gensler G., ”The Great Mutual Fund Trap”, Broadway Books, ISBN 0-7679-1071-0,2002

Bogle, John, “Happiness or misery?: Investment performance in a age of Investment Relativism ”, Remarks before the Washington D.C. Society of Investment Analysts, Dec. 16, 1997

Carrick Rob, ”Fees, Fees, Fees”, the Globe and Mail, April 26,2002

Chevreau, Jonathan “the Wealthy Boomer-Life After Mutual Funds”; Key Porter Books, ISBN I-55263-006-4, 1998

Chevreau Jonathan, ''Active'' managers are closet indexers: Several Canadian funds charge high fees to track indexes”, Financial Post Tuesday, July 15, 2003

Heinzl, Mark J. “ Stop buying mutual funds”-The book Bay Street Still Doesn’t want You to Read (2’nd edition); John Wiley and Sons Canada Limited, ISBN 0-471-64613-X, 2001

Kivenko, Ken, “Buying a Mutual Fund”, available from kenkiv@sympatico.ca., Doc. # MF112, July, 2002

Kivenko Ken, “ ETF’s –Another kind of Mutual Fund”, available from kenkiv@sympatico.ca. , Document MF # 115, September, 2002

Libin, Kevin,” Big bucks, big whammy –A study finds that when it comes to mutual funds, you get what you pay for-sometimes, “, Canadian Business, Aug. 19, 2002, pgs. 25 and 26

Thorley S.R., ”Beating the Odds: Active versus passive Investing”, Marriott Alumni Magazine (Marriott School/ Bringham Young University), Summer 2002

Warywoda, Mark,” What Canadians pay for fund management, June 10, 2003 (available at www.morningstar.ca) –The survey made several discouraging conclusions:

1. Despite tremendous industry growth, investors are generally not receiving the benefits of economies of scale

2. MERs for the average fund have increased significantly over time, even after accounting for the impact of segregated funds. Estimated average MER for all funds is up from 2.02% in 1995 to a historical high of 2.62% as of April 30, 2003

3. There are dramatic differences between the levels of fees charged by different fund sponsors.

4. Some of the largest fund sponsors, most notably Investors Group, are among the most expensive.

5. Funds with higher MERs tend to have lower star ratings and have had worse performance results than those with lower MERs, and vice versa.

6. Fund investors paid over $10 billion in management fees in 2002, up from $2.8 billion in 1995