Are You a Victim of Investment Duplication and Closet Indexing?

If you are like many Canadian investors, your RRSPs, TFSAs, personal or corporate non-registered investment portfolios may hold a number of mutual funds recommended by your financial advisor.

They may have told you that by holding a variety of mutual funds, you are well diversified and have not given it another thought (other than to make sure it is performing).

However, you may be less diversified than you think. You may own two or more Canadian mutual funds managed by different mutual fund managers, each working for different mutual fund companies. 

When you look under the hood, you may find that each of your mutual funds holds similar stocks in approximately the same proportions. This may also apply to your US and International mutual funds as well. While you hold multiple mutual funds, your portfolio may suffer from duplication of stocks and bonds across multiple mutual funds.

On further investigation, you may find that the weighting of individual stocks or bonds in your mutual funds represent similar weightings to a market index that fund would be compared to.

So, instead of having a well-diversified portfolio, your portfolio may be a victim of investment duplication and closet indexing.

So why then, would your typical mutual fund become a closet indexer?

Mutual fund managers are looking out for their own best interest instead of yours. Mutual fund managers are continuously measured by investment researchers, media, and the public against benchmarks.

Mutual fund managers’ paycheques and their jobs may depend on their performance compared to a benchmark. Therefore, these measurements may cause them to mirror a benchmark instead of actively managing the mutual fund, resulting in investment returns that may be very close to the benchmark returns before their management fees, but lag the benchmark after subtracting their management fee.

“The motivation for closet indexing grows out of years of poor performance and the ongoing shift from active to passive management. Flows out of active and into passive funds have topped hundreds of millions in assets under management for multiple years. This has put pressure on fund managers who fear the passive industry will eliminate stock-picking jobs.”[1]

The biggest issue I have with mutual fund managers claiming to be active portfolio managers is the relatively high management fee they continue to charge while taking a passive approach to investing when they should be charging a significantly lower fee more in line with index funds.

So that’s the problem. Is there a solution? 

Absolutely!  It’s called Discretionary Portfolio Management.

Discretionary Portfolio Managers must act with care, honesty, and good faith. They must always act in the best interest of their clients by designing portfolios that generate risk-adjusted returns that closely match their client’s risk profile. In other words, build portfolios on behalf of their clients that generate the best possible rate of return for a given level of risk (market volatility)  All their investment decisions, therefore, must be independent and free of bias.

I cover this extensively in my book Who’s Investing Your Money? – 7 Key Questions to Ask Your Financial Advisor. This book examines the various types of advisor registrations, their limits and abilities and will help you find the right advisor for you.

To learn more about how a Discretionary Portfolio Manager can better help you, please call me at (604) 855-6846 or email me at aspitters@pfcwealthsolutions.com

Who’s investing your Money is available as a free PDF download at www.whosinvestingyourmoney.com

Alternatively, the book is available from Amazon.ca as a paperback and Kindle version from this link: Who’s Investing Your Money? – Amazon

[1] Chen, James. “Closet Indexing.” Investopedia, Investopedia, 4 Dec. 2019, https://www.investopedia.com/terms/c/closetindexing.asp.

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