The Canadian stock market is relatively small by international standards and is dominated by a few large corporations. Indeed, the top 10 companies by market capitalization in the TSX Composite Index reads like a who’s who of corporate Canada, including four of the big five banks, Canadian National Railway, Enbridge, Suncor Energy and BCE.
With so much concentration, it’s not hard for a mutual fund manager to avoid dramatically underperforming the index by simply buying a basket of stocks that more or less mirrors the composition of the TSX composite.
That’s known as closet indexing, and it’s what a lot of mutual fund managers have been doing in Canada, according to a study in the Journal of Financial Economics. The study found that the Canadian mutual fund industry is one of worst offenders in the world when it comes to closet indexing.
The 2016 paper estimated 37% of the total net assets in equity mutual funds sold in Canada are closet indexed, compared to just 15% in the U.S.
Why is closet indexing bad? Because mutual funds marketed as being actively managed charge far higher fees than funds that passively track an index. And Canada has some of the most expensive actively managed mutual funds in the world.
So, in many cases, investors are paying exorbitant fees for the services of a fund manager who is essentially buying the index.
A couple of law firms have zeroed in on this issue in a proposed class-action lawsuit recently filed against TD Asset Management and RBC Global Asset Management and its subsidiary, Royal Trust.
The proposed lawsuit, which hasn’t been certified by a court, alleges that two popular funds—the RBC Canadian Equity Fund and the TD Canadian Equity Fund—use a closet indexing strategy “designed to closely track or replicate, not exceed, the funds’ benchmark index, the S&P/TSX Composite Index.”
The proposed class action, filed by Investigation Counsel P.C. and Bates Barristers, alleges that excessive fees paid to RBC and TD over the years “have significantly reduced the returns of investors and that investors are entitled to damages including restitution of excessive management fees,” according to a statement.
The Globe and Mail reported that management fees on the most common series of the two funds ranged between 1.6% to 1.85% during the class-action periods of June 2005 to present for the RBC fund, and June 2005 to present for the TD fund. In comparison, an iShares exchange-traded fund that tracks the S&P/TSX index, charges between .05% and .25%.
The Ontario Securities Commission looked into closet indexing as part of a 2016 review of active management practices by mutual fund companies. The OSC didn’t take any action but told the Globe it’s still monitoring the issue.
I wouldn’t hold my breath for regulatory action to stop closet indexing. Your best protection is to avoid actively managed mutual funds altogether.
Research plainly shows actively managed funds fail to beat the index on average. Whether the cause is high fees or closet indexing, the answer is to just say no to active management and yes to low-fee index funds.