Closet Indexing: The Cost of Falling Asset Management Fees

Abstract

In recent decades, investors have benefited from decreasing asset management fees and increasing availability of passive investment products. However, the practice of closet indexing, in which funds charge active management fees while closely mimicking a benchmark, has grown to include over 30% of mutual fund assets (Cremers and Petajisto 2009). We ask whether these trends are related, and develop a model to analyze how fees (in levels and types) affect funds' incentives to closet index. Building upon the notion that investors' flows compete away abnormal returns (Berk and Green 2004), our model endogenizes information production and closet indexing, and also decomposes fees into two components: passive fees for delegated portfolio management services and active fees for expected outperformance. Our analysis shows that lower passive fees lead to increased closet indexing and decreased information production. Rather than behaving as substitutes, where decreasing revenues from passive fees increase information production incentives, the two revenue sources are complementary. While investors benefit directly from decreasing costs of portfolio management, this result highlights an indirect cost: less active research may lead to less efficient prices. Furthermore, if given the ability to signal via a performance-based fee, high-skill funds forgo the option and only middle-skill funds adopt the signaling mechanism. This counter-intuitive result is driven by funds' desires to attract high AUM and high accompanying revenue from passive fees. For high-skill funds, relying on future performance to separate is less costly than charging performance-based fees, because retaining a portion of abnormal returns decreases AUM and rents from investors' passive fees.