Abstract
Actively managed mutual funds sell the potential to beat the market by picking stocks that are expected to outperform passive benchmarks like the S&P 500. Funds that are marketed as active vary substantially in the degree to which their portfolio holdings actually differ from the holdings of passive index funds. A purportedly active fund with a portfolio that substantially overlaps with the market is known as a closet index fund. Since closet index funds charge considerably higher fees than true index funds but provide a substantially similar portfolio, they tend to be poor investment choices. This article presents empirical evidence on closet index funds, showing that more than 10% of U.S. mutual fund assets are currently invested in closet index funds and that high cost closet index funds substantially underperform their benchmarks. We argue that persistent closet indexing implicates a number of legal issues, including possible liability for fund advisors under the Securities Act and the Investment Company Act. We conclude by discussing potential adjustments to mutual fund disclosures that could help investors identify closet index funds.
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