A Wolf In Sheep's Clothing, A study about potential closet indexing in the Swedish equity mutual fund industry.

Abstract

We measure the activity of Swedish domiciled equity mutual funds with Sweden as geographical investment universe, by calculating their active share with respect to major market indices like OMX30 GI and OMX Small Cap TR and retrieving tracking error and r-squared from Bloomberg. Afterwards we calculate the cost to investors by comparing the cost of investing in comparable explicit index funds and the cost of the closet indexers. Thus, we find that not only does the Swedish investment sector have a higher share of potential closet indexing than the comparable EU-wide ESMA report, but the cost to investors is substantial. We believe the practice of closet indexing in the Swedish sector and its prominence is of several reasons, one might be behavioural with bounded rationality and another reason could be market competition in the sense that explicit indexing is not yet popular enough in the Swedish sector to rid out closet indexing. However, there is also a dilemma active fund managers’ face with index-linked investing with regards to the price premium index-linked stocks enjoy and their co-movement with their index family rather than the market itself. There are also several factors like a funds size and portfolio managers’ career risk that needs to be taken into consideration as to why closet indexing exists. Our findings show that the problem of the activity in the fund industry is nuanced. However, whatever reason there may be for closet indexing, investors should always question what intrinsic value active managers give their portfolio.