What Are You Paying For?

'Closet index funds' have higher fees than true index funds but don't differ enough to justify the higher costs

The pact between a mutual-fund investor and the manager of the typical stock mutual fund is, in theory, a simple one: payment in exchange for expert stock selection.

But financial advisers have long complained there are funds that don't fully live up to that exchange. These funds charge high fees but follow a strategy that is very close to simply betting on an index. The supposedly active fund manager, in effect, is being paid for doing close to nothing.

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Investing with a "closet indexer" is a double whammy for investors: It lowers their odds of getting results that are far better than the benchmark, which is a key reason to opt for an active stock picker (although, to be fair, their chances of falling far behind are lower, too). And they may be paying substantial annual fees, and sometimes sales commissions, for fairly average returns.

In many cases, investors could benefit by moving some money to a cheap index-tracking fund with fees of less than 0.2% of assets a year or by investing with managers who happily veer from the index—or some combination of both.

"It's hard to make the case for index-huggers" that lag behind the index "and have higher costs," says Russel Kinnel, director of fund research at Morningstar Inc. "While the risks to your portfolio aren't great, investors are needlessly settling for mediocrity."

The Wall Street Journal went looking for closet indexers in one of the largest fund categories—large-cap blend funds, which typically compare their performance to the Standard & Poor's 500-stock index. The Journal asked Morningstar to identify large-cap blend funds with "R-squared" scores of more than 98% over the five years through Oct. 31. A fund's R-squared score, figured by comparing the fund's performance to a benchmark, measures the percentage of a fund's returns that can be explained by the index's movements.
Morningstar excluded from its screen enhanced index funds, which aren't quite index funds but also can't be called closet indexers. These funds, which include

Source: The Wall Street Journal | Wed, 12/09/2009 by: SAM MAMUDI