Index Hugger

What Is an Index Hugger?

The term index hugger refers to an actively managed mutual fund that, despite active management, performs like and tracks a major benchmark index like the S&P 500.

Actively managed funds are expected to outperform the so-called average performance produced by passively managed index funds, which is what attracts most investors. But they often come at a high price—the fees attached to index huggers are often much higher than those associated with more conventional investment vehicles.

Understanding Index Huggers

Mutual funds are investment vehicles that take money collected from a pool of investors and invest it into a variety of securities including stocks, bonds, cash, money market vehicles, and other assets. The type of assets a fund invests in is based on its investment strategy—a fixed income mutual fund invests in fixed income instruments while a global equity fund invests in international equities.

Mutual funds are generally divided into two categories—passive and active. Passive management styles limit the amount of buying and selling that takes place. The purpose is to buy and hold, building wealth over time rather than profiting off short-term gains in the market. Passive investing also limits how much investors pay in fees to the management company—something common with active management styles. Investments that are actively managed involve frequent buying and selling facilitated by a portfolio or investment manager who constantly monitors the market.

Hugging the Index

Index huggers are actively managed mutual funds that track major benchmark indexes like the S&P 500 or the Dow Jones Industrial Average (DJIA). Therefore, any movement in the index is mirrored in the corresponding fund. Investors who are keen on taking advantage of gains in a stock market index will likely benefit from investing in an index hugger. Their performance behavior gives investors reason to liken it to something of a closet index fund. Closet fund managers try to mitigate the risks associated with active management by tracking indexes.

Index huggers offer investors little in the way of benefit and are often considered exploitative because they seemingly take advantage of investors' lack of knowledge. They advertise market-beating returns that they cannot deliver, all while charging fees for the service. Fund companies typically benefit a great deal from the alternative—closet trackers. These vehicles are inexpensive and easy to operate. 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.

Special Considerations

Because the fees associated with index huggers may outweigh the benefits, many investors would be better off allocating their assets into a low-cost index exchange-traded fund (ETF). That's because the index hugger may not have the potential for a notable return when compared to these types of ETFs. 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.

The 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%. An R-squared of 100% means all movements of a security, or the dependent variable, are completely explained by movements in the index, or the independent variable. A high R-squared that falls between 85% and 100% 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.