Don't be fooled by the warm and fuzzy name - index huggers are arguably the most vile, misleading vehicles in the investment market. These funds, sometimes called "closet trackers" or "pseudo trackers", are mutual funds or portfolios of equities that are marketed as actively managed, but in fact keep so close to the relevant index, that one might as well have purchased a real tracker.

Let's look at a little analogy:

Imagine that you are sick - dying. You go to the hospital because the hospital promises to care for its patients and to give specialized treatment. You check in and pay the hefty fees, but instead of the personalized care you expect, the staff simply leave you in bed, letting nature run its course - for better or worse. This is the kind of care you get when you accidentally buy into a closet tracker. You'd have been better off taking your chances at home. You'd save money and wouldn't have any false assumptions.

These funds exploit investor ignorance, tricking people into paying for a service and a market-beating return that they won't receive. This article will explore the closet tracking phenomenon and show how you can avoid being the latest unsuspecting victim. (To begin with the basics, see The Lowdown On Index Funds.)

Closet Trackers Abound
Research conducted in the Edinburgh, Scotland, by market research firm The WM Company found that almost 75% of "active funds" deviate only marginally from their benchmark index.

The study covered data from 1980 to 2000, and found that 40% of supposedly active funds deviate by between 0-3%, and a further 34% by 3-6%. The study also found that roughly three-quarters (127 out of 168) of funds simply do not beat the index. (To read more about the study, see Investors Lose As Pseudo Trackers Come Out Of The Closet.)

Many Buy Into These Misleading Funds
The above statistics have alarming consequences, particularly for inexperienced investors who do not know how the investment industry works. These investors expect something very different from what they often receive.

Anyone who is aware of business cycles and market crashes would logically expect fund managers to ensure that their portfolios perform reasonably well in all market situations. They would expect each stock purchase to be carefully considered, for any changes in the market or with respect to the individual companies to be reflected in immediate sales and purchases and so on. For such individuals, the realization that their money is in a closet tracker can be a rude awakening.

This is surely the real danger of closet trackers. People believe their investments are being managed in such a way as to minimize potential losses. They feel safe leaving their money in the stock market, secure in the knowledge that their money is being looked after. Yet, a closet tracker will go up and down with the market, fully exposed to stock market cycles.

If the S&P index goes up (or down) by 5%, most American funds will go up (or down) by about the same amount. This is a fundamental reality of the investment industry, but the buyers of closet trackers are usually unaware of this reality - until the market takes a dive.

Why They Exist
These funds have little, if anything, to offer investors; however, for the fund company, closet trackers are great. They are cheap, easy to run and fees are paid for a non-existent service. Accordingly, closet trackers enable large brokerage houses to run - not manage - hundreds or even thousands of portfolios with a passive one-size-fits-all approach. It suits them just as much as it does not suit the investor.

Unfortunately, regulatory measures have not caught up with investor distress so far. If somewhere in the prospectus the fund mentions that it will attempt to mirror or track an index, then unfortunately it is a case of "buyer beware". The investor might think he or she is getting something tailor-made but the fine print says it's strictly off the rack (For more on the importance of reading the fine print, see Don't Forget To Read The Prospectus!)

Spotting a Closet Tracker
If you want a tracker, you're much better off buying a real one - you will pay much less in fees and will know what you are getting. However, if you want active management, you'll need to find a fund or broker that can outperform consistently in different market situations or one who does not even attempt to beat a benchmark. You may, for instance, prefer a small portfolio of 5-15 stocks, each genuinely actively managed with its own stop (buying or selling limits), ongoing monitoring and control and so on.

Index huggers are simply not "managed" in the true sense of the word. Unless a fund manager can, in some way, do better than the market itself in terms of returns, you do not need him or her. For a broker or fund manager, being a nice guy is not enough. No matter how charming the fund company of a closet tracker is, and irrespective of how glossy and impressive the brochures or internet sites are, these are bad investments in financial terms.

You can spot these funds by asking the right questions. These include:

  • What features do you offer that I can't get from a tracker (personalized information, communication, tailor-made portfolio)?
  • How exactly does your active management operate, and how does it help?
  • Do you benchmark with an index and if so, which one?
  • Do you beat it consistently and if so, by how much? (To learn how to measure your fund manager's performance, see Active Share Measures Active Management.)

Understand the Pitfalls of Both Styles Before You Buy

  • Active management - It is not easy to find a consistently outperforming fund or broker. Getting reliable information on performance is time consuming, can be complex and may not always be possible. Past performance simply cannot be extrapolated into the future. In short, you may prefer not to bother with the hassle of active management. (For more on the risks and rewards, see Words From The Wise On Active Management.)

  • Index Trackers -

There are different indexes and differently composed trackers. So, some homework or reliance on the seller is still needed. Either way, it is not all safe sailing. However, the fact remains that trackers are cheaper and, at least on a relative scale, you do really know what you are getting. There is no doubt that the tracker route is more transparent and straightforward. (For more, see You Can't Judge An Index Fund By Its Cover and Money Management Matters.)

The Bottom Line
Unfortunately, closet trackers will probably always exist. Closet trackers are just too cheap, easy to run and profitable, and there are just too many naive investors out there, for such funds to disappear. But, informed investors can identify and avoid them.

For the market as a whole, regulation and investor education are the solutions. Regulators need to ensure that firms and individuals are not allowed to sell funds that promise something they don't deliver - otherwise, the old "buyer beware" principle prevails, and many buyers are not and will never be aware of this problem.

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