By C. Thomas Howard, PhD, Athena Invest via Iris.xyz

We are witnessing a dramatic flow of money out of active equity mutual funds and a similarly sized flow into index funds. A large portion of these outflows are from so-called closet indexers, funds that claim to be active equity managers but, upon closer inspection, closely track an index while charging active fees. Investors have wised up to this and are heading for the exits, moving into much lower-fee passive funds that provide the same underlying equity return.

Many mistakenly believe that this is occurring because active investment teams are unskilled stock pickers, and this misunderstanding is the focus of this article. I argue that the returns generated by the skill of these teams can be overwhelmed by poor portfolio decisions and market environments that do not favor successful stock picking. As a consequence, the returns delivered to investors often are disappointing, underperforming the fund’s benchmark even when team members are skilled stock pickers.

Poor portfolio decisions are the result of industry incentives that drive active equity funds to turn themselves into closet indexers by creating an unhealthy environment that I refer to as the “closet indexing factory.” The resulting industry infrastructure encourages funds to capture all of the economic rents flowing from their skill, while delivering inferior returns to investors. It is the fruit of this misguided industry structure against which investors are rebelling.

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