Fund managers should go into the closet when markets drop

Fund managers have every incentive to mimic their benchmark when markets are down, according to researchers at Pace University and Touro College.
During up years, a strong relationship exists between fund performance and net flows. However, during down years, outperforming or underperforming a benchmark does not have a significant impact on the subsequent year’s flows.
This means that “there is an incentive for active managers to closet-index in down markets, as investors do not reward outperformance with higher flows,” according to the researchers, who recently conducted a study, “Is There an Incentive for Active Retail Mutual Funds to Closet Index in Down Markets? Fund Performance and Subsequent Annual Fund Flows between 1997 and 2011.”
Closet indexing, or mirroring the asset composition of a benchmark index, is the opposite of active fund management — the type of vigorous oversight for which investors are willing to pay top dollar.
“The basis for a fund manager’s income is usually net asset size,” said Matthew Morey, the New York Stock Exchange research scholar and professor of finance at Pace University. “In down markets, people have an aversion to taking their money out even if the fund is underperforming, but they also won’t put more money in if the fund is outperforming its benchmark index.”
“If you outperform everyone, you’re still not going to get inflows,” he said. “Let’s say you’re down 10%, but everybody else is down 20%. People aren’t going to be giving you assets like they would if you were up 20% and everybody else is up 10%.”
So why would active fund managers all of a sudden closet-index their asset allocation in the down market?
“Well, they wouldn’t have to do as much work,” Mr. Morey said. “When fund managers aren’t benefiting from performance, they’re incentivized not to work as hard.”
“Truly active management tends to do very well,” he said. “But if you charge the higher fees that go along with active management and you choose to closet-index, that fund ends up underperforming the generic index funds that charge very little in fees.”
The observed down-market helplessness is in marked contrast to heightened fund activity during up years. Mr. Morey sees human behavioral tendencies, including an overwhelming distaste for losing, as the basis for these misaligned incentives.
“There are widely disparate reactions to winning and losing,” he said. “Not only do losses hurt us more than gains perk us up, but we have this predisposition to want to get back to even.”