Do Active Managers of Retail Mutual Funds Have an Incentive to Closet Index in Down Markets? Fund Performance and Subsequent Annual Fund Flows, 1997-2011

Abstract

Closet indexing is the practice of staying close to the benchmark index while still claiming to be an active mutual fund manager and charging active-management fees. Recent work shows that active mutual fund managers are more likely to closet index during down markets. Around the time of the 2008 financial crisis, closet indexing became so popular that it accounted for about one-third of all mutual fund assets. In this paper we set out to answer the question of whether there is an incentive for mutual fund managers to closet index during down markets. We examine the relationship between annual fund performance and subsequent annual fund flows in up and down markets. We find that the relationship between fund performance and subsequent net fund flows is significantly different in up-market years compared with 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. In up-market years, we find a strong positive relationship between fund performance and subsequent flows. In downmarket years, we find that the magnitude of outperformance or underperformance does not significantly influence the next year’s fund flows. Based on these results, which show that investors do not reward outperformance in down markets with higher subsequent flows, we conclude that active managers have an incentive to closet index in down markets.

Keywords: closet index, active managers

JEL Classification: G10, G12