On the Impact of Closet Indexing in Active Fund Management
Wai Mun Fong, National University of Singapore

We propose a simple model to quantify the performance impact of closet-indexing in equity fund management, with a focus on mutual funds. The model requires only two inputs: the Sharpe ratio of the market index and the Rsquare from a regression of a fund’s excess returns on systematic factor returns. Due to pervasive closet-indexing, R-squares are uniformly close to one, regardless of the asset pricing benchmark. We show that closet-indexing leads to gross alphas that do not survive realistic trading cost and expense ratios.