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

14 Pages Posted: 23 Dec 2013

See all articles by Aron A. Gottesman

Aron A. Gottesman

Pace University - Lubin School of Business - Department of Finance and Economics

Matthew R. Morey

Pace University - Lubin School of Business - Department of Finance and Economics

Menahem Rosenberg

Touro College

Date Written: December 1, 2013

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

Suggested Citation

Gottesman, Aron A. and Morey, Matthew R. and Rosenberg, Menahem, 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 (December 1, 2013). Journal of Investment Consulting, Vol. 14, No. 2, 47-58, 2013. Available at SSRN: https://ssrn.com/abstract=2371371

Aron A. Gottesman

Pace University - Lubin School of Business - Department of Finance and Economics ( email )

One Pace Plaza
New York, NY 10038
United States
212-346-1912 (Phone)
212-346-1573 (Fax)

Matthew R. Morey (Contact Author)

Pace University - Lubin School of Business - Department of Finance and Economics ( email )

One Pace Plaza
New York, NY 10038-1502
United States
212-618-6471 (Phone)

HOME PAGE: http://webpage.pace.edu/mmorey/

Menahem Rosenberg

Touro College ( email )

1602 Avenue J
New York, NY 10010
United States

Register to save articles to
your library

Register

Paper statistics

Downloads
40
Abstract Views
432
PlumX