Tuesday, December 8, 2009

Beware of "Closet Index Funds"

Generally, individuals have two basic options when choosing an investment strategy. First, the investor can simply invest in index funds, which invest in a wide range of stocks or bonds whose performance should reflect that state of the economy as a whole. This strategy will almost certainly provide average results at a low cost. Second, investors can agree to pay a mutual fund manager a fee in exchange for the money manager's expert security selection. This strategy can produce results all over the map, ranging from top-of-the-class performance to bottom-of-the-barrel embarrassment. However, paying an "expert" investment manager will certainly cost more than simply investing in index funds.

The Wall Street Journal recently identified a handful of large-cap mutual funds that are not keeping their end of the bargain to attempt to provide superior security selection. These funds charge high fees but follow a strategy that is very close to simply betting on an index. These supposedly active fund managers, in, effect, are being paid for doing close to nothing.

These funds are termed "closet index funds" and hit investors with a double whammy: they lower the investor's odds of getting superior investment results, and they increase the annual fees and sales commissions charged to the investor.

To identify these index-huggers the Wall Street Journal looked for funds with "R-squared" scores of more than 98% over the past five years. A fund's "R-squared" score, figured by comparing the fund's performance to a benchmark, measures the percentage of a fund's return that can be explained by the index's movements.

It would be worth the effort to identify the "R-squared" score of each of your mutual funds in relation to their index to ensure you are paying managers who are actually pulling their weight. If you need help identifying the "R-squared" score of your investments, please reach out to me as I would be happy to help. By the way, the large-cap blend funds the Journal pinpointed were the Dreyfus Fund, Dryden Large Cap Core Equity, First Investors Blue Chip, Nationwide Fund, Principal Large Cap Blend Fund (both I and II), and the Thrivent Large Cap Stock fund.

1 comment:

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