What is an 'Index Hugger'

An index hugger is a type of managed mutual fund that typically performs much like a benchmark index, such as the S&P 500®or the Dow Jones Industrial Average. That performance behavior gives investors reason to liken it to something of a closet index fund. The majority of actively managed funds are expected to outperform the so-called average performance produced by passively managed index funds. So as an index hugger tracks benchmark indexes closely, the fees that accompany investment should steer investors in another, more cost-efficient direction.

BREAKING DOWN 'Index Hugger'

An index hugger is often seen as exploitative in investment circles. These types of funds seemingly take advantage of investors' lack of knowledge. They advertise market-beating returns that they cannot deliver, all while charging fees for the service. These funds offer investors little in the way of benefit. However, fund companies typically benefit a great deal from closet trackers. They are inexpensive, easy to operate and the fund receives fees for performing a service that is largely non-existent. Accordingly, closet trackers enable large brokerage houses to operate many different portfolios with a passive, one-size-fits-all approach. 

In most cases, investors would be better off allocating their assets into a low-cost index exchange-traded fund (ETF) rather than paying for an actively managed index-hugging fund without potential for a notable return. The only reason to consider paying higher costs for a managed fund is if the portfolio manager in question has a solid track record of outperforming the market. 

Index Huggers and R-squared Factor

Index huggers should bring the R-squared factor into play for investors as they perform their due diligence when determining whether to make an investment. In the investing world, R-squared is typically considered to be the percentage of a fund or security's movements that can be explained by fluctuations in a benchmark index. 

R-squared values range from 0 to 1 and are commonly stated as percentages from 0 to 100 percent. An R-squared of 100 percent means all movements of a security, the dependent variable, are completely explained by movements in the index, the independent variable. A high R-squared which falls between 85 and 100 percent suggests that the performance of the stock or fund moves relatively in line with the index. In this scenario, investors may be better off investing in the index itself, which has lower portfolio turnover and lower expense ratio features. 

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