'Closet indexing' can hurt investors, expert says

Investors continue to plow money into passively managed index funds while shunning funds that use active stock pickers.

Performance and lower costs are prompting investors to make the switch from active to passive funds, industry observers say.

The average annual expense ratio for passive funds was 0.17 percent in 2016 compared with 0.75 percent for active funds, according to investment research firm Morningstar. Meanwhile, nearly two-thirds of active funds that invest in large-company stocks lagged the S&P 500 last year and more than 90 percent of large-cap funds missed the benchmark over a 15-year period, according to S&P Dow Jones Indices.

Stock pickers mimicking the index is part of the reason many active funds fail to beat their benchmarks, said Martijn Cremers, a University of Notre Dame finance professor. The phenomenon is called closet indexing.

Managers are closet indexers because they don't want to lag too far behind the benchmark for fear of losing their jobs or their funds have gotten so big that they can't help but track the market, Cremers said.

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