Canadian Securities Course (CSC) Level 2 Practice Exam

How does closet indexing differ from traditional indexing in terms of fund replication and management approach?

1. Active management, replicates index exactly, high turnover rate

2. Passive management, replicates index exactly, low management fees

3. Passive management, doesn't replicate exactly, low turnover and fees

4. Active management, replicates index approximately, high fund fees

The correct answer is: Passive management, doesn't replicate exactly, low turnover and fees

Closet indexing is characterized by a passive management style, where the fund does not replicate the index exactly. Instead, it holds a portfolio that closely resembles the benchmark index but may have slight deviations. This approach allows the fund manager to attempt to outperform the index while still being largely aligned with it. Typically, closet indexing results in relatively low turnover compared to actively managed funds, as the strategy relies on maintaining a portfolio that mirrors the performance of the index rather than frequently buying and selling securities. This lower turnover contributes to reduced transaction costs, which helps keep management fees low. In contrast, traditional indexing aims to replicate an index as closely as possible, which usually results in lower fees and lower turnover rates. Active management strategies, on the other hand, might involve frequent trading and larger deviations from the index, potentially leading to higher fees and greater turnover. Therefore, the characteristics of closet indexing—passive management, approximate replication of the index, and lower fees and turnover—distinguish it from both traditional indexing and more active management approaches.