Beware of the Closet Index Fund

Low-cost index funds are the perfect buy-and-hold investment for busy investors. What isn't such a good deal are mutual funds that charge actively managed fund expenses for portfolios nearly identical to that of an index fund. Why pay more for less return? You can identify and avoid these closet index funds by inspecting their portfolios under a microscope.

Owning closet index funds costs you big time. The least expensive index funds charge less than 0.25 percent of your assets in ongoing expenses and charge no loads. A closet index fund might charge one percent or even more for the same basic performance. The Vanguard 500 Index fund, the nation's largest mutual fund, tracks the S&P 500 index and charges 0.18 percent of assets, which is far better than the 1.4 percent for the average, actively managed, large blend fund. Translated into dollars and cents, a $10,000 investment in the Vanguard 500 Index fund costs $18 a year, whereas a similar investment in an actively managed fund costs $140 per year -- more than seven times more. Hold that fund for even five years, and you'll pay at least $610 more than the fees for the index fund.

To check for index-hugging, first find a fund's benchmark index, either in a fund report or on the Morningstar web site. Focus on the following prioritized points to spot signs of index investing:

1. A fund with an R-squared of 90 or higher is a strong candidate for closet index fund status. The lower the R-squared, the lower the correlation between the fund's performance and that of the benchmark index.

2. A fund with a beta of 1.0 has performance volatility on par with the index. The more the beta value differs from 1.0, the less likely the fund mirrors the index.

3. Fund-data providers classify sectors differently, but a fund with sector weightings close to the index is likely a index-hugger.

4. Few funds beat indexes over the long term. Closet index funds might have performance close to the three- or five-year performance of an index fund, but are likely to fall away by 10 years because of the drag of their higher expenses. Managers with a more independent mindset are less likely to closely track index performance. For funds that charge a sales load, compare the load-adjusted returns to the index returns.

5. Average PE ratios within a point of the index are suspicious.

6. Average EPS within a percentage point of the index are suspicious.

7. You can compare either the top ten holdings or the entire portfolio to see how many companies are the same for the fund and its corresponding index, and look for similarities in the largest holdings.

8. As with sector weightings, a portfolio close to the index in terms of market cap is suspicious.

9. Indexes followed by foreign and world stock fund managers are strict in terms of the country weightings. Funds that don't go out of bounds are candidates for closet indexhood, while those that venture outside of their limits are run likely by more independent-minded managers.