Low-cost index funds are a genuine boon. Tracking broad or narrow sectors of the market, they are the perfect buy-and-hold investment for busy investors. What isn't such a good deal are mutual funds that charge actively managed fund prices for index fund investments. These funds range from big names with well-known managers to smaller, more obscure funds. Their portfolios are nearly identical to that of an index fund. Why pay more for less return—when a plain vanilla, low-cost index fund can do the job just as well? You can identify and avoid these closet index funds by inspecting their portfolios under a microscope.

The popular image of fund managers as swashbuckling risk-takers simply doesn't jive with reality. Institutional investors in charge of gigantic pension funds buy mutual funds that track sections of the market. Managers who stray from that safe niche could lose their asset management contracts and the fees that go with them. With corporate bean counters and institutional investors breathing down their necks, most fund managers can't afford to fall too far behind the averages, resulting in big fund complexes and obsessed managers who are trying to beat their peers and track the indexes. Taking the risks required to beat the index by a wide margin might not pay off, so most managers don't take them.

For those few managers who do take risks—many of whom are employed by smaller fund shops—their success in beating the market sows the seeds of their own downfall. It doesn't take long for investors obsessed with short-term returns to jump on the bandwagon and buy shares in successful funds. As assets grow, fund managers find it more and more difficult to craft a market-beating portfolio. Fund firms looking out for their investors often close such funds to new investments to preserve the manager's style and independence, but many fund firms won't take a step that crimps their own profits.

Owning closet index funds costs you big-time. The least expensive index funds charge less than 0.25 percent of your assets in ongoing expenses and carry no loads. Buy into a closet index fund that charges the average expense ratio for an actively managed fund, and you might pay 1 percent or even more. The Vanguard 500 Index Fund, the nation's largest mutual fund, tracks the S&P 500 index and charges 0.18 percent of assets, which is far better than the 1.4 percent for the average, actively managed, large-blend fund. Translated into dollars and cents, a $10,000 investment in the Vanguard 500 Index Fund costs $18 a year, whereas a similar investment in an actively managed fund costs $140 per year—more than seven times more. Hold that fund for even five years, and you'll pay at least $610 more than the fees for the index fund. Because costs directly reduce your bottom-line returns, you're not earning as much as you could. Add a front, back, or level load onto that higher expense ratio, and you'll dig yourself into an even deeper hole.

TIP

Some investors collect funds like other people collect antiques. When you collect four or more funds in the same investment style, you're setting yourself up for index-like returns. In fact, you're turning your own portfolio into a closet index fund and paying additional fund expenses to do so. Only buy a new fund if it is substantially different from the funds you already own.