To justify the high fees on mutual funds, their advocates will often use the argument that you are paying for the skill of the portfolio manager who is actively managing the fund. But just how active are most mutual funds?

Active Share

A measure called active share can help determine just how active your mutual fund is.

Active share compares the holdings of a mutual fund to its benchmark to determine just how different the mutual fund is from that benchmark. To score highly on the active share measure, the mutual fund would need hold different securities than the benchmark and/or hold some or all of the same securities but in different amounts than the benchmark.

An active share of 0 implies that the mutual fund tracks the benchmark very closely; most index funds should score near 0. An active share of 100 implies that the mutual fund has almost nothing in common with the benchmark (or possibly that the wrong benchmark was used).

The authors of a recent study, Indexing and Active Fund Management: International Evidence, suggest that a mutual fund with a score of 60 or above is an active fund, and anything lower than that means the fund is passive and can be considered a ‘closet index’ fund.

The Canadian Experience

In that study, the authors found that in Canada 37% of the assets in their sample were closet indexing, 55% were active, and the remaining 7% were explicitly index funds.

So 55% of the assets managed by mutual fund managers were active. That sounds good, right? Unfortunately, no. That was the lowest amount of any of the countries or regions studied. As well, 37% closeting indexing was the highest level of any of the countries or regions studied.

Why is Closet Indexing So High in Canada?

Canada has a relatively small stock market, dominated by a handful of large banks, so part of the reason for closet indexing may be down to that concentration. However, countries with even smaller stock markets like Ireland, Denmark and Finland showed lower levels of closet indexing.  This is likely an area for further research.

How do you know if your mutual fund is closet indexing?

Unfortunately, active share data is not easy to come by. Morningstar provided data to the Globe and Mail, which if you’re a subscriber, you can access here. If you’re not a subscriber, let me summarize the results for you:

Out of the 80 largest mutual funds that trade Canadian stocks, 60 could be identified as closet index funds. That’s 75%!!

So chances are, if you have a mutual fund with “Canadian Equity” in the name, your mutual fund may be nothing more than an expensive index fund.

Out of the 50 largest stock funds in Canada, that includes funds that trade Canadian and non-Canadian stocks or both, only 14 could be identified as closet index funds, a much lower 28%.

So it is quite possible that funds that trade non-Canadian stocks have a much easier time of being different from their benchmarks, hence the higher level of active share.

Why pay for active management if you’re not getting it?!

If Canadian mutual funds that trade Canadian stocks have the highest fees in the world (Canada scores the lowest with a D- from Morningstar on fees), and are not that different from their benchmark, why not just buy the benchmark and save over 2% per year?  It is quite easy to do with an ETF like the iShares S&P/TSX Capped Composite Index ETF (XIC) which has an MER under 0.10%.

Or if you don’t want to manage your own investments, you can open an account with ModernAdvisor and still save at least 1.5% per year.