The Mutual Fund Industry Worldwide: Explicit and Closet Indexing, Fees, and Performance *

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1 The Mutual Fund Industry Worldwide: Explicit and Closet Indexing, Fees, and Performance * Martijn Cremers, University of Notre Dame mcremers@nd.edu Miguel A. Ferreira, Nova School of Business and Economics miguel.ferreira@novasbe.pt Pedro Matos, University of Virginia Darden School of Business matosp@darden.virginia.edu Laura Starks, University of Texas at Austin laura.starks@mccombs.utexas.edu This Version: May 2013 Abstract We examine the causes and consequences of indexing for active management by equity mutual funds worldwide. Explicit indexing is rare in countries with weaker regulation and more developed stock markets, but many actively managed funds engage in closet indexing. We find that funds are more active and charge lower fees when they face more competitive pressure from explicitly indexed funds. Moreover, truly active funds generate higher risk-adjusted net returns than closet indexers. Overall, we conclude that explicit indexing improves the levels of competition and efficiency of the mutual fund industry in a country. Keywords: Mutual funds, Active management, Index funds, Exchange-traded funds, Competition, Fees, Performance JEL classification: G15, G18, G23 * We thank Wayne Ferson, Javier Gil-Bazo, Hao Jiang, Andrew Karolyi, Aneel Keswani, Borja Larrain, Lilian Ng, Henri Servaes, Michaela Verardo, and Jeffrey Wurgler; seminar participants at Arizona State University, Cass Business School, Cornell University, George Washington University, Imperial College, Instituto de Empresa, Rice University, State Street Global Advisors, Stockholm School of Economics-SIFR, Università Cattolica del Sacro Cuore, University of Colorado Boulder, University of Lugano, University of Mannheim, University of Melbourne, University of New South Wales, University of Sidney, University of Southern California, University of Technology Sidney, University of Utah, and University of Virginia-Darden School of Business; and conference participants at the 5th Biennial McGill Global Asset Management Conference, 5th Rotterdam School of Management Professional Asset Management Conference, 10th Rothschild Caesarea Center Conference, 2011 European Finance Association Meeting, 2011 Morningstar-Ibbotson Investment Conference, 2011 Morningstar Europe Conference, 2012 Inquire Europe Conference, 2012 SFS Cavalcade Conference, and 2012 American Finance Association Meeting for helpful comments. The authors acknowledge financial support from Inquire Europe and the European Research Council.

2 Practitioners and academics have long debated the societal benefits and degree of competition in the asset management industry, particularly among equity mutual funds. Beginning with Sharpe (1966) and Jensen (1968), academic researchers have debated the relative value of passive versus active management, and many have argued that indexed portfolios are superior investment vehicles. For example, Gruber (1996) questions the rapid growth in actively managed mutual funds, given evidence that their average performance is typically inferior to that of index funds. French (2008) and others argue that investors spend a significant amount on fees, expenses, and trading costs in actively managed funds that, on average, fail to beat market indices. Other studies, however, provide evidence that some mutual fund managers add value through active management. Grinblatt and Titman (1989, 1993) conclude that some fund managers are successful at beating their benchmarks before expenses; Kacperczyk, Sialm, and Zheng (2005) find that mutual funds with concentrated industry bets tend to outperform; and Cremers and Petajisto (2009) show that funds whose holdings are most different from their benchmarks (i.e., truly active as opposed to closet indexers) outperform their benchmarks net of fees. 1 Mutual funds have grown over the last half century to become one of the primary investment vehicles for households worldwide. Nearly 28,000 equity funds and $10.5 trillion in assets under management were recorded as of December 2010 (Investment Company Institute (2011)). The percentage invested in explicitly indexed funds has grown rapidly over the last decade from about 14% of assets under management in 2002 to about 22% in These explicitly indexed funds have thus become an increasingly important low-cost alternative to investment in stock markets as they have substantially lower fees than active funds in all countries. So what are the implications for active funds of the entry and growth of passively managed 1 For evidence on mutual funds, see also Wermers (2000), Bollen and Busse (2001), Avramov and Wermers (2006), Kosowski, Timmermann, Wermers, and White (2006), and Kacperczyk and Seru (2007). For evidence on pension plans, see Dyck, Lins, and Pomorski (2011) and Andonov, Bauer, and Cremers (2012). 1

3 funds? We hypothesize that if we hold the mutual fund customer base fixed, the introduction of explicitly indexed funds should lead to more competition; active funds should reduce their fees (the price ) or and differentiate their portfolios more (the product ). 2 Yet, market frictions, information asymmetries and less-than-perfectly competitive markets may allow active funds to maintain their market share and avoid having to lower fees or differentiate their products. Investors might base their decisions on fund attributes other than returns, such as fund family size, tax exposure, services, or investment strategies. Hortacsu and Syverson (2004) show considerable information/search frictions even for a homogeneous product such as an S&P 500 index fund. 3 In the case of active funds, investors may consider mutual funds to be heterogeneous products and find it difficult to distinguish between skilled and lucky managers. Investors may have heterogeneous beliefs in managerial skill. Some investors may believe in market efficiency, while others have strong priors on the presence of skill in the mutual fund industry. Berk and Green (2004) and Pastor and Stambaugh (2012) argue that fund managers may have skill and investors may want to invest in active funds even in the absence of ex post average positive alphas. Fund management companies can also create a perception among investors that they offer a differentiated product by expanding product offerings to preserve rents. Such actions could slow down investor learning about the benefits of indexed funds. 4 2 For research on competition in the U.S. mutual fund industry, see, for example, Baumol, Goldfeld, Gordon, and Koehn (1990) and Coates and Hubbard (2007). 3 An expansion in fund choices could increase the population of investors using mutual funds for the first time. In this case, novice investors with high information/search costs could flock to the relatively more expensive funds. Hortacsu and Syverson (2004) find a rightward shift in the fee distribution of S&P 500 index funds in the late 1990s at the time of new fund introductions. In an experimental setting, Choi, Laibson, and Madrian (2010) find that not all investors pick S&P 500 index funds solely on the basis of fees. Collins (2005) explains how differences in services and characteristics of the index funds can influence their expense ratios. 4 Carlin and Manso (2011) refer to this practice as obfuscation. In addition, indexed products could reduce search costs and force active funds to differentiate by becoming more niche players (Bar-Isaac, Caruana, and Cunat (2012)). 2

4 We study whether the presence of passively managed funds increases competition and efficiency in the asset management industry. We test whether the enhanced competitive pressure created by the presence of passive funds (as proxied by the market share and fees of explicitly indexed funds) increases active funds product differentiation (as proxied by deviations of fund holdings from the benchmark) and reduces the price paid for active management (i.e., the fees charged). Ultimately, what investors care about should be risk-adjusted net returns that mutual funds deliver. Thus, we study whether the most active funds display better net performance. Using a new data set on open-end equity mutual funds and exchange-traded funds (ETFs) in more than 30 countries over , we find considerable cross-country variation in the prevalence of indexing. In the United States, the market share of index funds and ETFs (explicitly indexed funds) grew from 16% of assets under management in 2002 to 27% in In other countries, explicit indexing is less prevalent but growing faster, from 6% in 2002 to 13% in Figure 2 shows these time series patterns. Interestingly, the popularity of indexing has increased after the financial crisis as the market share of explicitly indexed funds increased. Furthermore, no explicitly indexed funds seem to be offered at all in some countries. Our worldwide sample provides a unique setting to test the effects of growth in explicitly indexed funds on competition in a mutual fund industry, because there is wide variation in the availability of indexed products and regulatory and market environments across countries. Despite the relatively small amount of explicit indexing, we find that closet indexing is frequent especially outside the United States. Using the Cremers and Petajisto (2009) active share measure, which captures the proportion of fund holdings that differs from a fund s benchmark, we find that outside the United States about 30% of the assets are managed by closet 3

5 indexers (funds with an active share below 60%). 5 This is twice the level of closet indexing in the United States. The relative levels of explicit and closet indexing vary across fund investment strategies. Country- and regional-focused funds tend to have higher levels of closet indexing than world funds, especially for non-u.s. funds. For example, 50% of the assets in domestic country funds domiciled outside the United States are in closet index funds versus 14% for those domiciled in the United States. Cross-country regressions indicate that explicit indexing is more frequent in countries with stronger fund regulatory environments and with larger and more efficient stock markets. In contrast, we find that these factors have opposite effects on the frequency of closet indexing. We find that competition from explicitly indexed funds appears to affect active funds in several ways. First, actively managed funds have higher active shares in countries with more explicit indexing. This is consistent with the idea that explicit indexing forces active fund managers to differentiate themselves from low-cost passive alternatives. Second, the prevalence of explicitly indexed funds in a country is negatively related to fees charged to investors in active funds. Figure 3 reports the time series evolution of fees for active, closet indexers and explicitly indexed funds. Explicitly indexed funds have significantly lower fees and closet indexers charge fees as high as those of truly active funds. The figure shows evidence of a decrease in fees for closet indexers in the U.S. during the sample period, but much less outside the U.S. We provide more formal tests at the country-level showing that active funds tend to charge higher fees in countries with more closet indexing. These findings support the idea 5 We cannot differentiate between closet funds that do not attempt to deviate from their benchmarks from those that commit resources to ex ante identify private information but find ex post they failed in identifying such opportunities and therefore end up sitting on the benchmark. Observationally these are equivalent, as both funds exhibit low active share measures. 4

6 that the pervasiveness of explicit indexing leads to more competition, while more closet indexing in a country s fund industry reflects a lack of competitive pressures. These results hold whether a fund s market of operation is defined according to its legal domicile or according to countries where the fund is sold. A potential concern with these findings is that the availability of indexed funds in a country is endogenously determined and causality may run from the level of fees of active funds to the market share and cost of explicitly indexed funds. We address the endogeneity concern using as instrumental variables methods to estimate the effect of indexed funds on fees charged by active funds. As instruments, we use variables that are correlated with prevalence of explicitly indexed funds but uncorrelated with fees charged by active funds except indirectly through other independent variables. The instruments are the number of stocks and the average stock volatility in a country, which affect the attractiveness of indexed funds, and the prevalence of defined contribution pension schemes in a country, which is likely to increase the demand for passive investment options. The results are robust to corrections for endogeneity using instrumental variables methods. These results should, however, be interpreted with caution, especially because no strong theoretical justifications exist for the instruments for indexed funds. Finally, we find that active share predicts future fund performance. The most active mutual funds outperform their benchmarks after fees, while closet indexers underperform. Figure 4 shows batting averages, defined as the percentage of fund-year observations with positive benchmark-adjusted returns (i.e., when a fund s net return exceeds the return on its benchmark). The majority of active funds underperform their benchmarks between 2002 to 2010 both in the U.S and elsewhere. We find that the batting averages for truly active funds are better than those for closet indexers. Interestingly, batting averages are higher for U.S. funds, albeit more volatile. 5

7 The result that truly active funds perform better holds for different measures of performance including benchmark-adjusted returns and four-factor alphas and are economically significant. A one standard deviation increase in active share is associated with an increase of about 1% per year in future benchmark-adjusted returns and 0.7% per year in future four-factor alpha. There is also some evidence that returns to active management are higher in countries where low-cost passive alternatives are more popular. This is consistent with the idea that only skilled managers will survive in an environment with enhanced competitive pressure from index funds and ETFs. In contrast, the evidence does not support the idea that the growth of index-based investing could lower fund managers incentives to manage their portfolios actively (Wurgler (2011)). Overall, our findings suggest that the availability of explicit and closet indexing is a key determinant of competition in mutual fund industries around the world. We conclude that explicit indexing is associated with improved levels of competition and efficiency in a fund industry, while closet indexing is indicative of the reverse. Our work adds to the understanding of the structure of the asset management industry worldwide. The few papers analyzing mutual funds worldwide have so far focused on the determinants of industry size and fees across countries. Khorana, Servaes, and Tufano (2005, 2009), for example, find a link between the level of development of fund industries worldwide and a combination of legal, regulatory, and demand- and supply-side factors. To the best of our knowledge, we are the first to study the causes and consequences of explicit and closet indexing for the industrial organization of the mutual funds around the world. 6 6 Related work by Wahal and Wang (2011) shows that the entry of new mutual funds in the U.S. industry that are close substitutes for incumbents (as measured by overlap in portfolio holdings) forces incumbents to reduce fees. 6

8 I. Data and Variables Our analysis uses two primary databases: Lipper and FactSet/LionShares. The Lipper database provides a comprehensive sample of mutual funds offered and sold across a large number of countries. We focus exclusively on open-end domestic and international equity mutual funds and exchange-traded funds (ETFs) in the period. From this database we obtain individual fund characteristics, such as fund name, domicile, investment style, sponsor, benchmark, monthly returns, total net assets (TNA), fees, and expenses. The Lipper database is survivorship bias-free, as it includes both active and defunct funds. Although multiple share classes are listed as separate observations in Lipper, they have the same holdings, the same manager, and the same returns before expenses. Thus, we keep as our unit of observation the share class that Lipper identifies as the primary share class and aggregate fund-level variables across the different share classes. 7 Table IA.I in the Internet Appendix provides summary statistics of all variables for the sample of open-end active funds in the period, and Table IA.II reports time series averages of country variables per country. Appendix B provides all variable definitions. The LionShares database covers portfolio equity holdings for institutional investors worldwide, including mutual funds and ETFs. Ferreira and Matos (2008) provide a detailed description of this database. We match the Lipper (fund characteristics and performance) and LionShares (fund holdings) databases by CUSIP, ISIN, or fund name. We identify funds nationalities by their legal domicile, which characterizes the relevant regulatory and legal system. The funds are domiciled in 32 countries across several regions: North America (Canada, the United States); Europe (Austria, Belgium, Denmark, Finland, 7 We run some robustness tests using individual share classes. 7

9 France, Germany, Italy, the Netherlands, Norway, Poland, Portugal, Spain, Sweden, Switzerland, the United Kingdom); Asia-Pacific (Australia, China, Hong Kong, India, Japan, Malaysia, Singapore, Taiwan, Thailand); other regions (Brazil, Israel, South Africa); and off-shore (Ireland, Liechtenstein, Luxembourg). 8 Mutual funds, while taking a variety of names around the globe, are fairly comparable investment vehicles worldwide (Khorana, Servaes, and Tufano (2005)). 9 Table I provides some key statistics for the sample by country of domicile as of December We report these statistics for the 20 major European and North American countries and combine the Asia-Pacific countries into one observation in Table I because the holdings data are limited for many funds in those countries. We also combine the statistics for other regions. Table I shows that the 24,492 funds in the sample have TNA totaling over $9.8 trillion across the 32 countries. 10 Equity mutual funds domiciled in the United States represent the majority of the TNA (over $5.7 trillion), but other markets are also sizable. The Lipper s coverage of funds can be compared with aggregate statistics on mutual funds from other sources. As of December 2010, Investment Company Institute (2011) reported a total number of equity mutual funds worldwide of 27,754 with a TNA of $10.5 trillion. We conclude that our sample is nearly comprehensive of the equity mutual fund universe. Table IA.III in the Internet Appendix provides details on the number of share classes by country of domicile and country of sale in While for a majority of funds the country of domicile corresponds to the single country of sale, some funds are registered for sale in multiple countries, so there is effectively competition across domiciles. Funds domiciled in countries such as Canada and the United States are mostly sold in their home markets, but funds domiciled in 8 We require a minimum of 50 funds to include a country in the sample. 9 The European Union, in an attempt to create a harmonized mutual fund industry, has adopted a common definition: UCITS (Undertakings for Collective Investment in Transferable Securities). In addition, the EU has adopted the European passport system (Directive 2001/107/EC), which facilitates cross-border marketing of UCITS. 10 Mutual funds held roughly 20% of world market capitalization as of December

10 other markets such as France, Germany, the United Kingdom, and off-shore (Ireland, Luxembourg) are typically approved for sale in several markets. Because some funds have multiple share classes and are offered in more than one country, we can have multiple observations in a given year for the same fund. Table I shows that detailed portfolio holdings are available from LionShares for 11,776 funds with TNA of approximately $7.9 trillion. In total, we have holdings data from the LionShares database for about 81% of the TNA in the Lipper database, but coverage varies across countries. For the 20 countries in North America and Europe, we have portfolio holdings for about 86% of the countries TNA in the Lipper database. This compares to portfolio holdings for only 32% of the TNA of funds domiciled in Asia-Pacific countries and 22% in the other regions. 11 Table I also reports the number of funds per country by funds declared investment type according to their prospectus: ETFs, index funds, and active funds. There are a total of 10,558 active funds in our sample as of 2010 (2,606 in the United States). Explicitly indexed funds include 561 ETFs and 657 index funds (308 and 239 in the United States). Assets under management amount to a total of $1.7 trillion in explicitly indexed funds and $6.2 trillion in active funds. Although passively managed funds have become increasingly popular, active funds still dominate the mutual fund industry both in the United States and elsewhere. II. Explicit and Closet Fund Indexing Around the World First, we document the availability of explicitly indexed funds across different countries and benchmark types. We use holdings-based measures to classify active funds into truly active or closet indexers and describe the level of fees charged to investors across countries. 11 LionShares coverage of fund holdings is lower in some countries because disclosure is not mandatory. We obtain similar results when we exclude these countries, such that our results are not driven by selective disclosure. 9

11 A. Explicit Indexing Table I shows that 22% of equity mutual fund assets under management worldwide are explicitly indexed as of We define as explicitly indexed funds both index funds and ETFs. 12 The countries with the highest levels of explicit indexation are Switzerland (58%), Ireland (31%), the United States (27%), and France (25%). At the same time, some countries have almost no passively managed funds domiciled within the country. Investors in these countries which include Italy, the Netherlands, and Portugal, are still able to purchase index funds and ETFs that are offered in these countries but domiciled elsewhere. For example, large asset managers such as Vanguard and BlackRock manage index funds and ETFs domiciled in Ireland and offer these funds across several European markets. We conclude that there is substantial variation across countries in the degree to which fund assets are explicitly indexed. 13 B. Active Fund and Closet Indexing Although explicit indexing is rare in many countries, mutual fund managers classified as active may in fact practice a form of closet indexing (i.e., their fund holdings could be quite similar to the holdings of their benchmark index), while still marketing themselves and charging fees as if they engage in active management. To the extent that fund holdings overlap with index holdings, investors are effectively earning index-like gross returns, which they could obtain at lower fees through index funds or exchange-traded funds (ETFs). We measure the prevalence of closet indexing among active funds in a country using the active share measure developed by Cremers and Petajisto (2009). The active share of a fund 12 We consider ETFs to be passive products. Of course, ETFs can also be used by investors for market timing and other active investment strategies. 13 Calculation of the market share of explicitly indexed funds does not require LionShares holdings data. To investigate the possibility of selection bias from using the sample of 11,776 funds with holdings data in LionShares, we calculate the market share of explicit indexing using the sample of 24,492 funds in Lipper (i.e., including those without a match to the holdings data). The degree of explicit indexation is similar to that reported in Table I. 10

12 represents the share of portfolio holdings that differs from the benchmark index holdings and is calculated as: Active Share,, (1) where w fund,i and w benchmark,i are the portfolio weights of stock i in the fund and its benchmark index, respectively, and the sum is taken over the universe of stocks. For a mutual fund that never shorts stocks and never buys on margin, its active share will always lie between zero and 100%. Given our international setting, funds may hold different securities in the same company (e.g., common shares, depository receipts, and dual listings) that constitute fundamentally the same ownership stake in a company. We therefore sum all holdings in the same company as part of the same portfolio position. Our analysis of active management requires funds benchmarks and these benchmarks can be self-declared ( Fund Manager Benchmark ) or assigned by Lipper according to a fund s investment strategy ( Technical Indicator Benchmark ). We rely primarily on the Technical Indicator Benchmark both because the Fund Manager Benchmark is sparsely available and to avoid the concern that a fund manager may strategically choose a benchmark in order to rise in the performance rankings. 14 Appendix A lists the 88 specific benchmarks (Technical Indicator Benchmark) that Lipper assigns funds in our sample, which can be classified into three types: world (funds that invest worldwide), regional (funds that invest in a specific geographic region), and country (funds that invest in a specific country). Some of the world, regional, and country funds may have specific industry or investment styles Results using the Fund Manager Benchmark are consistent with all the results we report. 15 The sample includes only funds whose benchmarks have at least $10 billion of assets under management in

13 We construct portfolio weights for the 88 different benchmark indices using the aggregate portfolio holdings of the explicitly indexed funds tracking each benchmark. 16 Use of the actual weights of explicitly indexed funds tracking each benchmark has the advantage that some of the weights in the official benchmark include stocks that in practice may not be fully investable by mutual funds due to illiquidity or other constraints. In effect, the active share is measured in excess of explicitly indexed funds. On average (TNA-weighted), active funds in our sample have an active share of 69%, while passive funds have an active share of 16%. 17 The final columns in Table I provide the distribution of the active share measure for the sample of actively managed funds domiciled in each country as of We use an active share below 60% as the cutoff for an active fund to be classified as a closet indexer as in Cremers and Petajisto (2009). 18 All other funds with active share above 60% are classified as truly active. We find there is a wide range of closet indexing across countries. Although in the table we report active share statistics for 2010 only, we find that the active share of funds is an extremely persistent fund attribute over time (the pooled average serial correlation of active share at the fund-level is 0.95). Figure 1 compares the market share (as a percentage of TNA) of explicitly indexed funds, closet indexers and truly active funds across countries as of Countries are sorted, in ascending order, by the market share of truly active funds. The United States has one of the 16 The benchmark weights are calculated excluding synthetic ETFs that do not physically replicate the underlying benchmark index. In addition, for about 2% of the fund-year observations where there are not at least five explicitly indexed funds tracking a particular benchmark, we use as an alternative the aggregate portfolio of all active funds that track that benchmark. 17 The average active share of passive funds varies across benchmarks. For example, passive funds that track the S&P 500 index have an average active share of 4%. 18 An active share of 60% means that 40% of the fund portfolio weights overlap with the benchmark index weights. The 60% cutoff is somewhat arbitrary, but as, on average, half the holdings in any portfolio will beat the portfolio s average return, then an active fund (with a manager who tries to beat the benchmark) should have an active share of least 50%. In addition, the 60% threshold corresponds to classifying funds in the bottom tercile of the distribution of active share as closet indexers. 12

14 highest levels of explicit index management (with 27% of assets managed by index funds and ETFs), as well as the lowest level of closet indexing among all countries, at 15%. In countries with little explicit indexation, the actively managed funds domiciled there are relatively passive, as measured by their active shares. For example, Canada has a low level of explicit indexation at 7% but a high level of closet indexing at 37% of fund assets under management. Figure 2 shows the time series of the market shares of explicitly indexed funds, closet indexers, and truly active funds over the period. Panels A and B show the evolution in the United States and elsewhere, respectively. Explicit indexing has been increasing over time in both the United States and other countries. While assets under management by active funds dropped during the financial crisis (from $7 trillion in 2007 to $6.2 trillion at the end of 2010), explicitly indexed assets actually grew over the period (from $1.3 trillion to $1.7 trillion) with a big part coming from the growth of ETF assets (from $0.6 trillion to $0.8 trillion). The amount of closet indexing in the United States appears to have remained relatively stable over time with some decline during the financial crisis. Outside the United States, closet indexing has dropped significantly over the sample period. In robustness checks, we use two alternative methods to calculate active share. First, we construct the index weights based only on ETFs that undertake full physical replication of the indices. For the majority of the 88 benchmarks, we can identify a SPDR or ishares ETF that tracks these benchmarks. We call the active share measured against the ETF weights the pure- ETF active share. Second, to address any potential issues with Lipper s assignment of the Technical Indicator Benchmark to each fund, we construct the active share against all possible 88 benchmarks. We take the most representative benchmark for a fund at each particular time as the one with the lowest active share in the manner of Cremers and Petajisto (2009). We call this 13

15 alternative measure the minimum active share. We find that in our sample both of these alternative measures are highly correlated with the original active share (correlation coefficients of 0.97 with the pure-etf active share and 0.94 with the minimum active share). For active funds, the average (TNA-weighted) pure-etf active share is 70% and the minimum active share is 65% which are very similar to the levels of our main measure of active share. C. Explicit and Closet Indexing by Benchmark Type A fund s active share may depend on the opportunities and constraints provided by the investment opportunity set of the fund manager, which differ across benchmarks. Table II shows the total net assets (TNA) and the market shares of explicit and closet indexing per country as of December 2010 in the three different benchmark types: world, regional, and country funds. We further separate funds with a country benchmark into domestic (funds that invest in stocks of the same country where they are domiciled) and foreign (funds that invest in stocks of a country different from the one where they are domiciled). Table II also shows that the majority of equity mutual fund assets are invested domestically ($4.4 trillion). The next most prevalent type of fund is regional funds ($1.8 trillion), followed by world funds ($1.2 trillion), and foreign country funds ($437 billion). However, the proportions are not universal across countries. For example, domestic funds are predominant in the U.S, but world and regional funds are relatively more important in European countries. Table II presents the amount of explicit indexing per country according to fund benchmark type. The level of explicit indexing is highest for domestic country funds, where 27% of the fund assets are indexed. Explicit indexing is used somewhat less frequently for world funds (12%), regional funds (18%), and foreign country funds (18%). In addition, closet indexing is less common for funds pursuing global investment strategies (11%) than for regional funds (24%), 14

16 domestic country funds (21%), and foreign country funds (27%). The diversity in the universe of stocks tracked by each benchmark has implications for the measurement of active share. For example, the SSgA World Index Equity Fund that tracks the MSCI World index (the most popular world index) includes over 1,600 stocks at the end of 2010, while the SPDR S&P 500 ETF Trust tracking the S&P 500 index (the most popular country index) have 500 stocks. Some of the other explicitly indexed funds do not engage in full physical replication. For example, the average index or ETF fund tracking the S&P 500 has an average of 334 stocks. Thus, the definition of active versus the benchmark depends in part on the number of stock positions a fund needs to replicate its benchmark. We take into account this effect and other fund, benchmark, and country characteristics in the analysis of active share below. D. Fees We measure fees and expenses charged to mutual fund shareholders using the total expense ratio (TER) and loads. This category is broader than just management fees and includes all annual expenses that a fund charges its investors for investment management, administration, servicing, transfer agency, audit, and legal. TERs exclude certain distribution fees, such as frontend or back-end loads, as well as annual fees charged by distributors that are separate from the fund charges. Following Khorana, Servaes, and Tufano (2009), we calculate average total shareholder costs (TSC) per year for a fund investor, defined as TER plus one-fifth of the front-end load. This calculation assumes the typical investor holds a fund for five years, and that rear-end loads are waived if the fund is held for that length of time. The TERs are more comparable across countries than management fees, which may include payments for administration and distribution in some countries, but not others. If information on TER is not available (13% of the 15

17 fund-year observations), we use the annual management fee instead, which constitutes a lower bound for the TER. 19 Table III reports average (TNA-weighted) TSC per country as of the end of The first column shows that the TSC varies considerably across countries, from an average of 0.99% per year for funds in the United States to an average of 3.58% for funds in Poland; non-u.s. funds average 2.07%. Thus, consistent with Khorana, Servaes, and Tufano (2009) we find that shareholder costs in the United States are much lower, on average, than in other countries. The next columns in Table III show the average TSC separately for the three types of funds: explicitly indexed funds, closet indexers, and truly active. Figure 4 illustrates the range of the average TSC across the three types of funds in a country. Not surprisingly, explicitly indexed funds have the lowest costs, with an average TSC of 0.35% per year versus 1.64% for active funds. The costs for explicitly indexed funds are lower than for active funds across all countries, but again the United States stands out as having the lowest cost for explicitly indexed funds at 0.26% per year. In most countries, closet indexers are as costly as truly active funds, with an average TSC of 1.64% and 1.66% per year, respectively. These summary statistics confirm that explicitly indexed funds are a low-cost alternative to active funds worldwide and that closet indexers, which offer gross returns similar to passive funds, charge fees that appear indistinguishable from those of truly active funds. Figure 3 reports the time series evolution of fees and shows evidence of fee reduction for closet indexers in the U.S., but more limited outside the U.S. The final columns in Table III show average TSC across the different benchmark types: world, regional, and country. Most importantly, there are generally greater differences across 19 The TSC ignores bid-ask spreads in the case of ETFs, which are typically narrow. For example, Morningstar (2012) reports that the Lyxor ETF Euro Stoxx 50 (the largest ETF on the Euro Stoxx 50 index) had a trailing 30-day average spread of 0.017% at the NYSE Euronext Paris as of February28,

18 countries than across benchmark types within countries. III. Determinants of Explicit and Closet Indexing Across Countries We hypothesize that explicitly indexed funds provide a low-cost substitute for active funds, which could lead to more intense competition in the fund industry. To test our hypothesis, we employ two measures of competition in a country s fund industry: the market share (percentage of total net assets, TNA) and the fees (average total shareholder cost, TSC) that explicitly indexed funds charge. Product differentiation is another way we can see competition in the industry. Closet indexers offer a less differentiated product at high fees and may reflect a less competitive market. For these reasons, we use the market share of closet indexers as a measure of the lack of competition in a fund industry. We expect the levels and costs of explicit and closet indexing in a country to depend on several factors, most particularly the funds regulatory environment, the size of and competition in the fund industry, and the level of stock market development in the country. Khorana, Servaes, and Tufano (2005, 2009) show that stronger regulations and laws are related to relatively larger mutual fund industries and lower costs for fund investors. We expect to find more low-cost explicitly indexed products in environments where regulation is stronger, and specifically where mutual fund investor rights are better protected. Beside regulation, fund industry development should matter in the case of the breadth of fund offerings. We expect the overall size and concentration in an industry to positively affect the decision to introduce explicitly indexed products. Stock market conditions should also matter because they determine how easy it is to assemble passive products. Thus, explicitly indexed products are more likely to be offered in larger stock markets. Table IV provides results on the determinants of explicit and closet indexing across countries 17

19 over In Panel A, we focus on the country in which the fund is domiciled. We use two measures of explicit indexing as dependent variables. Explicit Indexing (% by country) is the market share of explicitly indexed funds as a percentage of the TNA in each country in a given year. Explicit Indexing (TSC by country) is the TNA-weighted average total shareholder cost (TSC) of explicitly indexed funds in each country in a given year. We also use a measure of closet indexing as dependent variable. Closet Indexing (% by country) is the market share of active funds with an active share below 60% as a percentage of the TNA in each country in a given year. We examine the potential country-level determinants in separate regressions because there are a limited number of countries in our sample. In columns (1), (4), and (7) we test whether indexing is related to the country regulatory environment. Specifically, we use the extent to which regulatory approvals are required for fund management companies (approval) and the quality of a country s judicial system (judicial) as in Khorana, Servaes, and Tufano (2009). 20 We find that in countries with a more efficient judicial system and a stronger rule of law there is more and cheaper explicit indexing and less closet index. A more restrictive regulatory approval regime of new funds is positively associated with explicit indexing. Specifically, in column (1) we find a positive and significant coefficient on both the approval and judicial variables, which indicates that the market share of explicitly indexed funds increases with the quality of the regulatory environment. The economic impact of approval is considerable. For example, an increase in approval from one to two is associated with an increase of about 6% in the market share of explicitly indexed funds. A one standard deviation increase in judicial (7.01) is 20 Approval is the sum of two dummy variables: (1) whether regulatory approval is required to start a fund and (2) whether the prospectus requires regulatory approval. Judicial system quality is the sum of five variables (all variables are scaled between 0 and 10): the efficiency of the judicial system, rule of law, corruption, risk of expropriation and risk of contract repudiation. 18

20 associated with an increase of about 3% in the market share of explicit indexing. Column (4) shows lower TSC for index funds in countries with more investor protection as measured by the judicial variable. The approval variable is not significantly related to fees. The judicial variable, however, is negatively associated with the level of closet indexing in a country as shown in column (7). We study the relation between indexing and characteristics of a country s fund industry. The results are shown in columns (2), (5) and (8) of Table IV. We use the size and level of concentration of the fund industry in the domicile country and the gross domestic product (GDP) per capita as explanatory variables. Fund industry size is defined as the aggregate TNA of all equity mutual funds in the country, and the concentration of the industry is measured by the fund industry Herfindahl based on the market shares of fund families in the equity fund markets. Columns (2) and (5) show that the availability and cost of explicit indexing in a country are significantly related to the size of a country s fund industry. The larger the size of the fund industry, the greater the market share of explicitly indexed funds and the lower their cost. In addition, column (8) shows that the greater the size of the fund industry, the lower the level of closet indexing. These results are consistent with the idea that industry development and economies of scale make it easier to offer low-cost explicitly indexed products and, at the same time, to mitigate closet indexing among active funds. Industry concentration is significantly related only to the market share of explicitly indexed funds. Columns (3), (6), and (9) of Table IV examine the relation between indexing and stock market conditions in the domicile country as proxied by number of stocks, average stock volatility, and a dummy that takes the value of one in countries where the prevalent pension scheme is defined contributions (DC pensions dummy). The degree of explicit indexing 19

21 increases with the number of stocks traded on a country s stock markets. Similarly, the cost of investing in explicitly indexed funds declined with the number of stocks and volatility of the market. Closet indexers have a larger market share in countries with smaller stock markets. The analysis so far assumes that a fund is offered for sale exclusively in the country of domicile, although some funds are offered for sale in multiple countries, and competition effectively occur across domiciles. We run all regressions in Panel A of Table IV with the market share and cost of explicitly indexed funds and the market share of closet indexers (as well as other country characteristics) calculated by country of sale, rather than by country of domicile. The results reported in Panel B are in general consistent with those in Panel A. The results suggest that strong rule of law and larger mutual fund industries and stock markets promote explicit indexation, while discouraging closet indexing by active fund managers. We further refine the analysis by measuring explicit and closet indexing separately by benchmark type (world, regional, country-domestic, and country-foreign) in each domicile country or country of sale. The results (reported in Table IA.IV in the Internet Appendix) are robust to this alternative way of measuring the availability and the cost of explicitly indexed funds. Stock market conditions of the domicile country (or country of sale) directly affect the investment opportunities of domestic mutual funds but only indirectly in the case of foreigncountry, regional or world funds. In Table IA.V in the Internet Appendix, we show that the results are robust when we rely only on the sample of domestic funds to estimate the countrylevel indexing dependent variables. Overall, we conclude that explicit indexing in mutual funds is more prevalent and cheaper in countries with stronger regulation, larger fund industries, and deeper stock markets, while closet indexing is less prevalent. 20

22 IV. Does Competitive Pressure by Explicitly Indexed Funds Affect Active Funds? We next study the impact of explicit indexing on active funds in terms of product differentiation (degree of activeness) and the price that investors pay for active management (total shareholder costs). The tests use the panel of active equity mutual funds for the period from 2002 to A. Product Differentiation Explicitly indexed funds are low-cost substitutes for the more expensive actively managed funds. We expect higher market penetration by indexed products to create competitive pressure on active funds. One possible reaction is that the active fund managers will differentiate themselves by deviating from their benchmarks through more stock picking, sector bets, and market timing. We expect higher product differentiation among active funds, as proxied by active share, when investors are offered a more distinct choice between active and passive funds. To test this hypothesis, we estimate panel regressions in which the dependent variable is the yearly fund-level active share, and the main explanatory variables are the market share of explicit indexing or the average total shareholder costs (TSC) of explicitly indexed funds domiciled in the same country as the fund. We control for fund characteristics, fund benchmark characteristics (number of stocks, volatility) or fund benchmark dummies, dummies for particular types of funds (international, fund of fund, off-shore), and country characteristics. Regressions include year dummies, and standard errors are clustered by domicile-year or country of sale-year. Table V presents the results. Columns (1)-(4) show the results when we measure the indexing variables by country of domicile. Columns (5) and (6) show the results when we measure the indexing variable by country of sale to take into account that a fund can be offered for sale in 21

23 multiple countries. Since a fund can have multiple share classes with diverse fee schedules offered to different investors, we run the regressions in columns (5) and (6) using the individual share class offered for sale in a country in a given year as a unit of observation. 21 We find that active funds have higher active shares in countries where the average TSC of explicitly indexed funds is lower. Columns (2), (4), and (6) show that the average TSC of explicitly indexed funds coefficient is negative and significant, which suggests that funds choose higher active shares and engage in truly active management when faced with more competitive pressure from explicitly indexed funds. Economically, a standard deviation increase in the TSC of passive funds (0.53) is associated with an increase in average active share of almost 2%. Thus, results are consistent with the hypothesis that active funds perceive explicitly indexed funds as a competitive threat when the explicitly indexed products are a low-cost alternative. We find that active funds have higher active shares in countries where explicitly indexed funds have a higher market share, but this effect is statistically significant only when we define the explicit indexing variable by country of sale in column (5). Fund benchmark conditions are also important determinants of the level of active share. Funds that track benchmarks with more stocks tend to be more active. In addition, active share is related to a country s regulatory and fund industry environment. In countries with higher approval requirements and judicial quality, funds are more active, suggesting that stronger legal rules encourage active management. We also find that funds are more active in competitive fund industries such as larger and more contestable industries. The regressions also show that active share is higher for funds with higher tracking error, 21 A fund with two share classes, each offered for sale in three countries, will have six different observations per year in this sample. In these tests, fund-level variables are measured at the individual share class level, and countrylevel variables are measured by the country of sale. The indexing variables - market share and cost of explicitly indexed funds and the market share of closet indexers - are measured by country of sale. 22

24 funds with higher TSC, smaller funds, younger funds, and funds in smaller fund families. More successful fund managers in terms of past performance and attracting more inflows have higher active shares. These coefficients are in line with those in Cremers and Petajisto (2009). The active share regression results are robust in several ways. In Table IA.VI in the Internet Appendix, we measure the indexing variables by country of domicile/benchmark type. In Table IA.VII in the Internet Appendix, we estimate the regression using the non-u.s. fund sample, as funds domiciled in the United States represent a large fraction of the observations. We also consider alternative methods to estimate active share such as the pure-etf active share and the minimum active share. Finally, we conduct several robustness checks. First, we estimate the regression model using weighted least squares, where the total net assets of the fund are employed as the weights, following Khorana, Servaes, and Tufano (2009). Second, we estimate regressions using domicile country fixed effects. All these robustness checks produce results consistent with those in Table V. Finally, in Table IA.VIII in the Internet Appendix, we show that the results are robust when we rely only on the sample of domestic funds. In this sample where closet indexing is most prevalent, the effect of explicitly indexed funds on the active share of active funds is more pronounced. A one standard deviation increase in the TSC of passive funds is associated with an increase in average active share of almost 3%. We find one additional result: the market share of passive funds is positively associated with the degree of activeness of mutual funds. B. Total Shareholder Costs We study whether the availability of explicit and closet indexing in a country affects the price that investors pay for active management. Given that passive funds are a low-cost alternative to active funds, we expect fees charged by active funds to be negatively related to the 23