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The Benefits of ‘Closet Indexing’

According to academic research from 1997-2011, investors will reward funds that outperform their benchmarks when the market is up but not when it’s down. When the market experienced negative returns, the research found, there was no significant effect on flows when comparing funds that outperformed their benchmark versus funds that underperformed.

Why? Because people are reluctant to lock in losses even if a fund tanks — demonstrating that loss aversion trumps more rational behavior. So fund managers who are paid on flow would do better to “closet index” their benchmark in down years rather than trying to beat it. The downside is that funds that closet index will underperform their benchmarks due to higher fees.

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