Closet indexing is a strategy used to describe funds that claim to actively purchase investments but wind up with a portfolio not much different from the benchmark. This essentially means investors are not actively seeking out good stocks. They rather run behind the stocks making the index.
Different drawbacks for different players
1. When a retail investor does closet indexing, he is not doing due diligence in picking stocks.
2. Fund managers are expected to beat or atleast secure draw with the index. If managers are not taking the risk of finding good stocks, they would tow index's line. In such cases, fees that investors pay for the manager becomes unnecessary. Retail investors are better off buying index funds with much lesser fees.
3. Going blindly with stocks representing the index would invariably reinforce the idea that those stocks are good stocks. This positive spiral will bloat the stock prices of the index stocks.
Different drawbacks for different players
1. When a retail investor does closet indexing, he is not doing due diligence in picking stocks.
2. Fund managers are expected to beat or atleast secure draw with the index. If managers are not taking the risk of finding good stocks, they would tow index's line. In such cases, fees that investors pay for the manager becomes unnecessary. Retail investors are better off buying index funds with much lesser fees.
3. Going blindly with stocks representing the index would invariably reinforce the idea that those stocks are good stocks. This positive spiral will bloat the stock prices of the index stocks.
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