ESMA working paper on Closet indexing indicators and investor outcomes

09 September 2020

Closet indexers appear to pass on to consumers only a small share of the lower economic costs of benchmark-tracking compared to active management, rather than engaging in price competition.

This paper examines how different measures of closet indexing relate to costs and performance among EU-domiciled equity funds with active mandates. To capture different hallmarks of closet indexing we study a range of metrics, conducting panel regressions using annual fund-level data for 2010-2018. In addition to the portfolio-based Active Share we use three return-based metrics: Tracking Error, R2 and Beta. We develop a combined indicator to study the joint effects of the return-based metrics and verify that it predicts Active Share. Turning to our main results, potential closet indexing is associated with lower performance, including for risk-adjusted performance (alpha) net of costs. Potential closet indexing is associated with slightly lower total costs, though far above those for passive funds. Closet indexers therefore appear to pass on to consumers only a small share of the lower economic costs of benchmark-tracking compared to active management, rather than engaging in price competition.

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