Is there an Incentive for Active Retail Mutual Funds to Closet Index in Down Markets? Fund Performance and Subsequent Annual Fund Flows between 1997 and 2011
28 Pages Posted: 7 Jan 2013 Last revised: 27 Aug 2019
Date Written: October 2013
Closet indexing is the practice of staying close to the benchmark index while still maintaining to be an active mutual fund manager and probably also charging fees similar to those of truly active managers. Recent work shows active mutual fund managers were much more likely to closet index during down markets. Indeed, closet indexing became so popular that it accounted for about a third of all mutual fund assets during time surrounding 2008. In this paper we set out to answer the question of whether there actually is an incentive for mutual fund managers to closet index during down markets. To do this we examine the relationship between annual fund performance and subsequent annual fund flows in both up and down markets. Using this approach we find that the relationship between fund performance and subsequent net fund flows is significantly different in up markets years as compared to down market years. Specifically, we find that fund performance does not drive subsequent flows nearly as much in down markets as it does in up markets. Indeed, in up markets, we find a strong positive relationship between fund performance and subsequent flows. Conversely, in down years, the amount of outperformance or underperformance does not significantly influence the next year’s fund flows. Hence, based on these results, there is an incentive for active managers to closet index in down markets as investors do not reward outperformance with higher flows.
Keywords: Closet Indexing, Mutual Fund Flows, Down Markets
JEL Classification: G21, G23
Suggested Citation: Suggested Citation