Behind the active cover of some funds there is a strategy that hardly deviates from the index. But there are clear thresholds by which closet indexing can be recognized.
• Index hugging refers to actively marketed funds that secretly follow an index
• BaFin issued binding transparency requirements for German sales prospectuses in 2017
• BaFin examined 290 German equity funds and identified individual suspicious cases
What index hugging means and why regulators intervened
Index hugging describes the practice of marketing a fund as actively managed and charging correspondingly high management fees, even though the investment strategy is actually closely based on a reference index. As can be seen from the interpretative decision of the Federal Financial Supervisory Authority of April 4, 2017, the English term “closet indexing” describes a fund “that is very closely based on a reference value and therefore appears to pursue a more passive investment strategy”, whereby the investor is not sufficiently informed about the actual investment policy in the sales documents or is even misled.
In 2016, BaFin examined a total of 290 German equity funds and identified individual suspicious cases without identifying any actively marketed pure index replicas. As a consequence, the supervisory authority obliged capital management companies to state in the sales prospectuses from December 31, 2017 at the latest whether a fund is actively or passively managed, to name any reference value, to explain possible maximum deviations and to graphically compare the performance of the fund and reference value over ten years. At the European level, the European Securities and Markets Authority (ESMA) had already warned in its public statement of February 2, 2016 and, together with national supervisory authorities, introduced a threshold grid, which ESMA has since continued in its own investigations and in the annual reports on the costs and performance of investment products in the EU.
Three metrics that can be used to identify index huggers
In its supervisory practice, ESMA relies on a combination of three return-based metrics: tracking error as the annual standard deviation of the return difference between the fund and the index, the coefficient of determination R² as the proportion of the fund return that is explained by the index return, and beta as a measure of sensitivity to index movements. As ESMA Working Paper No. 2 from September 2020 with the title “Closet indexing indicators and investor outcomes” documents based on around 5,400 EU-domiciled equity funds for the period 2010 to 2018, a fund is considered a possible index hugger if the tracking error is below 3 percent, the R² is above 95 percent and the beta is between 0.95 and 1.05. In addition, there is the portfolio-based indicator Active Share, which, according to Martijn Cremers and Antti Petajisto, indicates closet indexing at a value below 60 percent, which the international study by Cremers, Ferreira, Matos and Starks in the Journal of Financial Economics from 2016 confirmed for the global fund market.
If you want to check an actively marketed fund, you can find these key figures in the fact sheets of reputable providers, in the key investor information or on data platforms such as Morningstar. The ESMA combination of tracking error, R² and beta is the more robust diagnosis because a single value can be misleading. The beta for systematic factor bets is typically still close to 1, while the tracking error can increase solely due to a consistent sector deviation without any actual active selection taking place. Only the combination shows whether a fund essentially delivers the index return minus fees.
What the extra charge for incorrect activity actually costs
The study in ESMA Working Paper No. 2/2020 shows that potential closet index funds are, on average, only around 6 basis points cheaper in terms of total expense ratio than really active funds, but at the same time deliver a significantly lower alpha return, i.e. a lower risk-adjusted added value compared to the index. The majority of the economic advantage that a passive approach brings to the provider is not passed on to the investors. The ESMA Market Report on the costs and performance of EU investment products from March 3, 2026 as of the end of 2024 shows how current this pattern is: Active equity UCITS in the EU had ongoing costs of an average of 1.28 percent over the one-year horizon in 2024, while passive non-ETF equity UCITS were at 0.22 percent and equity ETFs at 0.21 percent came. In terms of performance, active equity UCITS generated a net return of 17.0 percent in 2024, compared to 21.3 percent for passive non-ETF equity funds and 21.4 percent for equity ETFs. This means that investors paid on average around six times as much in running costs and in return received a performance that was over four percentage points weaker. Anyone who relies on an active fund that is also in the closet indexing corridor combines the poorer relationship between costs and performance with the structural lack of real active selection.
The SPIVA Europe Year-End 2025 Scorecard from S&P Dow Jones Indices, a division of S&P Global, provides international confirmation of this finding. As can be seen from the scorecard of March 19, 2026, 71 percent of all global equity funds from Europe denominated in euros underperformed the return of the S&P World in 2025, while for pan-European equity funds in euros it was 82 percent compared to the S&P Europe 350. A concrete test method can be derived from this for active investors. Anyone who finds an explicitly named reference value in a fund prospectus since the BaFin requirement of 2017 should combine the ten-year comparison prescribed in the prospectus with the ESMA threshold combination: If the fund moves within the closet indexing corridor in terms of tracking error, R² and beta, the management fee can hardly be justified with active added value. This shifts the economic question from “passive or active” to “active in demand or active in implementation”.
Dominik Maier, editorial team at finanzen.net
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