Closet Indexing: Revealing The Dirty Little Secret Of Canada’s Mutual Fund Industry

For years I’ve railed against Canada’s mutual fund industry for high fees, conflicts of interest, underperformance, poor disclosure, and lack of accountability. But today I’m going to zero-in on another major problem with mutual funds in Canada – closet indexing.

Canadian equity mutual funds sold by Canada’s big banks, in particular, are some of the biggest offenders. The CIBC Canadian Equity Fund (CIB479) closely resembles the S&P/TSX 60 Index – a fund made up of Canada’s largest companies. The fund does not attempt to differentiate itself from the index, yet it charges a management expense ratio (MER) of 2.20%.

The 10-year performance of the S&P/TSX 60 Index is pretty solid with an annual average return of 7.97% (June 30, 2021). A passively managed Canadian equity ETF like iShares’ XIU with an MER of 0.18% returned 7.80% per year over 10 years.

But CIBC’s Canadian Equity Fund returns have been abysmal by comparison, at just 5.70% per year for the decade.

Is that surprising? It shouldn’t be. A fund that makes no meaningful attempt to differentiate from the index stands no chance of beating its benchmark. It makes an already difficult task (beating the market) impossible. Add a grossly expensive 2.20% MER and you have a closet indexing laggard.

CIBC’s fund is a bit player in the market, with assets under management of around $595 million. By comparison, TD’s Canadian Equity Fund manages $5.8 billion in assets. It’s a cash cow for TD and its advisors, charging a similarly outrageous 2.19% MER.

The fund holds 60 large-cap Canadian companies and once again makes no real attempt to stand out from the broader Canadian index. The result? An annual return of just 5.30% over the same 10-year period.

Canada’s Closet Indexing Problem

“If you deliver index-like returns, you should charge index-fund-like fees.”

That’s what American researchers concluded in 2015 when they revealed that the Canadian mutual fund industry is the world leader in closet indexing. Estimates showed that about 37% of the assets in equity mutual funds sold in Canada are in closet index funds.

The key takeaway here is that if your portfolio is made up of mutual funds sold to you by your bank advisor, it’s highly likely that they’re closet index funds. Closet indexing means you’re paying higher fees than necessary while getting less than your fair share of market returns.

Not all mutual funds are bad, however. Index mutual funds, for example, track a broad stock index such as the TSX or S&P 500. Returns mimic the stock market index, or benchmark, that the fund tracks, minus a small management fee. On the flip side, some mutual funds attempt to beat returns from a broader stock market index by taking a more active role in selecting stocks and timing the market.

Related: The Vanguard Effect On Mutual Funds, Fees, and Performance

Firms such as Mawer have had a successful long-term track record in large part because their holdings differentiate from the index that it’s trying to beat. Mawer’s Canadian Equity Fund (MAW106) has delivered returns of 9.50% annually over the last decade, compared to the S&P/TSX Composite Index, which returned 7.97% over the same period.

The jury is out as to whether Mawer can continue this outperformance into the future, but the company has two things going in its favour.

For one, Mawer charges relatively small fees for its mutual funds. The Canadian equity fund, which manages $823 million in assets, charges 1.17% MER, which is more than a full percentage point lower than what the closet indexing big bank mutual funds charge.

The second advantage Mawer has over the big banks is that its funds tend to have a high active share, an indicator which measures how much a fund’s portfolio deviates from its benchmark.

A fund with an active share of 0 is identical to the underlying index (i.e. a closet indexer), whereas a fund with an active share of 100 has nothing in common with the index.

In Mawer’s Canadian Equity Fund you’ll find the usual suspects such as Shopify, RBC and TD, Telus, CP and CN Rail. But the fund is limited to 46 holdings instead of 60-62, and within it you’ll also find smaller firms like Ritchie Bros, Stella-Jones, and Richelieu Hardware, to name a few.

These smaller, more concentrated bets help differentiate Mawer’s fund from the big banks’ closet indexing funds. 

Note that a passive investing approach is significantly more likely to deliver better and more reliable returns over the long term. A past successful track record is no guarantee of future success. The point is if you want to bet on the very small chance of outperforming the market then you’ll need to avoid a closet index fund and choose something that is different than the index.

Final thoughts

Canadian investors pay too much and get too little in return. Closet indexing is one of the main reasons why. All of the banks have index mutual funds in their line-up, but your advisor has little incentive to even mention them to you. That’s because it’s “suitable” to sell you a higher fee closet index fund, even though it’s in your best interest to pay less and get better returns.

DIY investors have more options. Index ETFs track the broader stock market and most charge even less than the cheapest index mutual funds. Stock pickers can follow a dividend growth or value strategy to mimic their own Mawer fund, minus the management fee.

The bottom line is that if you discover your portfolio is filled with nothing but closet indexing mutual funds, ask your advisor about a lower cost index fund solution, or switch to a robo-advisor that can manage a low-cost portfolio of index ETFs on the cheap.

Finally, if you’re comfortable enough to go it alone, open up a discount brokerage account and find an investing strategy that works for you.