On the Impact of Closet Indexing in Active Fund Management

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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.

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.

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