** Special to the Just Word Blog from Robin Powell, the UK based editor of The Evidence-Based investor and consultant to investors, planners & advisors **
Imagine paying premium prices for a luxury sports car, only to discover you’ve actually bought a basic economy vehicle with fancy badges. This scenario plays out daily in Canadian investment portfolios, where hundreds of thousands of investors unknowingly pay premium fees for bargain-basement performance.
Welcome to “closet indexing”, where funds marketed as “actively managed” essentially mirror index performance while sometimes charging fees 10 to 20 times higher than genuine passive alternatives. This systemic issue has quietly drained billions from Canadian retirement savings.
An academic study in 2013 found that 37% of Canadian active fund assets exhibited characteristics of closet indexing, and little has changed in the intervening years. A landmark 2024 academic paper by University of British Columbia law professor Maziar Peihani concluded that “closet indexing remains overlooked” in Canadian regulations, creating “a significant gap in investor protection”.
Now, Canadian investors are fighting back. In February 2025, the British Columbia Court of Appeal delivered a groundbreaking ruling, certifying a class action against HSBC Global Asset Management on behalf of investors who alleged they were overcharged for funds marketed as actively managed but operated like passive index trackers. For the first time, investors don’t need to prove fraud, just that they were misled.
What is Closet Indexing? And Why Does it Matter?
Closet indexing occurs when a mutual fund markets itself as “actively managed” but closely tracks a market benchmark (the index it claims to beat) like the S&P/TSX Composite Index. You’re promised professional stock pickers who will beat the market. Instead, you get a fund that copies an index while charging handsomely for the privilege.
The deception lies in something called “Active Share” — a measure of how different a fund’s holdings are from the index it’s supposed to outperform. Genuine active funds typically have Active Share above 80%, meaning most of their stock picks differ from the index. Closet indexers often fall below 60%, with some as low as 20-30%. They’re essentially holding the same stocks as the index.
The fee differential can create devastating long-term damage. A typical Canadian index fund charges 0.05 to 0.25% annually. Including the cost of transactions, closet index funds can charge 1.5% to 2% or more for essentially the same thing.
Here’s what that means for your wallet: If you invest $10,000 in a low-cost index fund charging 0.20% annually, after 25 years with 7% market returns, you’d have approximately $52,400. The same investment in a closet index fund charging 2.0% would leave you with just $42,200.
That’s like handing over more than $10,000 of your hard-earned savings — just in fees — for no extra performance.
Canada’s Closet Indexing Problem: Among the World’s Worst
Canada stands out globally for having one of the highest concentrations of these pseudo-active funds worldwide. The 2015 study examined mutual fund markets across multiple countries and found Canada’s 37% figure among the highest globally.
This isn’t an accident. The mutual fund companies are very strong lobbyists, and have a sales system that rewards high-fee products.
Compare this to other markets: Europe has begun to crack down hard on closet indexing, with regulators imposing fines and forcing fee reductions. The United States has generally lower fund fees and greater transparency requirements.
Professor Peihani’s 2024 research shows how entrenched this problem has become in Canada. Despite various reforms, closet indexing itself has never been directly addressed. “The issue of closet indexing has been conspicuously overlooked in Canadian mutual fund regulation,” he writes.
The Lawsuit that Changed Everything
The February 2025 BC Court of Appeal ruling represents a seismic shift in how Canadian courts view closet indexing claims. For years, investors struggled to gain legal traction, with courts dismissing cases for failing to prove deliberate fraud.
Plaintiff Linnea Gibbs alleged that HSBC’s actively managed funds were actually passively managed, resulting in investors being overcharged. What makes this ruling groundbreaking is simple: the court said you don’t need to prove fraud — just that you were misled.
The HSBC case had been rejected twice before succeeding on appeal. The court established multiple legal pathways for investors, including breach of trust and failure to comply with disclosure rules. None require proving intentional deception.
The case now moves forward as a certified class action, potentially affecting all investors who held units in HSBC’s equity fund from January 2005 onwards. It sends a clear signal that the era of consequence-free closet indexing may be ending.
How to Spot a Closet Index Fund
Closet indexing isn’t impossible to detect. Here are some warning signs:
Check Active Share: If a fund discloses this figure and it’s below 60%, be suspicious. Many Canadian funds don’t publish Active Share, which itself should raise red flags.
Examine holdings: Look at a fund’s top ten holdings in Fund Facts documents. If these mirror the largest companies in the benchmark index in similar proportions, you’re likely looking at a closet indexer.
Watch performance patterns: Genuinely active funds should show periods where they significantly outperform or underperform their benchmark. Closet indexers track their benchmark closely with only minor variations.
Analyze fees versus results: Any Canadian equity fund charging more than 1.5% annually that consistently delivers index-like returns is suspicious. If a fund charging 2.0% delivers similar results to an index fund charging 0.20%, you’re paying 1.8% extra for nothing.
How to Protect Your Savings
If you suspect you own closet index funds, don’t wait. Here’s what to do:
Take immediate action: Calculate any redemption fees and determine whether paying them once is better than continuing to pay excessive ongoing charges. Moving to genuine low-cost index products will save substantial money over time, even after exit fees.
File complaints if needed: Start with your fund company, then escalate to your provincial securities regulator or the Ombudsman for Banking Services and Investments (OBSI).
Consider legal options: The HSBC ruling shows these cases can now proceed without proving fraud.
Most importantly, vote with your feet. Your money is your vote.
Why ETFs are Often the Better Choice
For most Canadian investors, low-cost passive exchange-traded funds (ETFs) represent a superior alternative:
Dramatically lower costs: Investing in a broad-market ETF typically costs around a tenth of what you pay to invest in a closet index fund and because fees compound over time, it means you pay far less in the long run.
Complete transparency: Unlike mutual funds that disclose holdings quarterly, most ETFs publish their complete holdings daily. You know exactly what you own, with no hidden strategies.
Reliable performance: A well-constructed index ETF will closely track its benchmark, typically within 0.1-0.3% annually after fees. You won’t beat the market, but you’ll capture virtually all of its returns — which is better than most expensive “active” funds achieve.
Professional management without the premium: Alternatively, firms like Justwealth provide professionally managed portfolios using low-cost ETFs, while delivering dedicated portfolio management services at a fraction of the cost of traditional active management. This approach combines the cost efficiency of ETFs with professional oversight and rebalancing.
While Justwealth provided financial support for this article, the views and opinions expressed are those of the author and do not necessarily reflect the views of Justwealth, or its employees. The content of the article is provided solely for information purposes only and should not be construed as advice of any kind.
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