Consumer Reports often compares generic products and their higher-priced branded counterparts in the pharmacy and the grocery aisle. But recently, academics have made a similar comparison when it comes to financial products.

Professors from four universities have published research that examines the relationship between index-based mutual funds—funds made up of investments that allow them to closely track an index, such as the Standard & Poor's 500 Index—and actively managed funds, which are run by managers who use their judgment and analytical skills to make investment decisions. For that service, actively managed stock funds have expense ratios that average nearly 1 percent annually making them more expensive than index funds.

In their research, the academics found that there were a number of funds that were being sold as actively managed—and charging higher fees—when in fact they were far more similar in their makeup to index funds. Such funds are colloquially known as "closet indexers" or “index huggers.”  If you have money invested in one of these, you are paying retail prices for generic performance. 

Regulators in Europe have recently turned their attention toward index hugger funds, where fund selection is much more limited than in the U.S. In some countries, these funds hold as much as half of the assets available to its nation's investors.

In the U.S, where investors have more choice, the index hugger isn't as insidious a problem. Even so, investors are not immune from the problem. A recent study focusing on "tax-managed" stock funds, for example, concluded that those funds seem to follow simple index-tracking strategies, while charging investors higher fees. Nor did they appreciably save on taxes compared to index funds, which are naturally tax efficient (most index funds only buy and sell when there's a change in the underlying index).

How to Test for Index Hugging

Regulators in the U.S. don’t police against the activity, so here the onus is on you to do your homework to see if you have an index hugger in your portfolio. When considering a fund as an investment, look at the R-squared, which shows how much of a fund's performance is explained by it's similarity to an index. For an index fund, like the Vanguard 500 index fund, the R-squared score is 1.00, or perfect. The closer the score is to 1.00, the more of an "index hugger" it is. Although there's no definitive R-squared score that makes a fund a closet indexer, anything above 0.90 should raise eyebrows and lead you to consider switching to an index fund instead of paying the fees.