The Active Bets You Take in Picking Index Investments

Many advisors love index funds for providing cheap, broad-based exposures to asset classes without having to trust a portfolio manager’s judgement. But some may chafe at the description of their strategy as hands-off.

Vanguard, not surprisingly, also takes issue with those who conflate index investing with passive investing. And they are now giving advisors hard data to back up what they know: index fund selection is active management, too, and not just something anyone can do.

The thesis: if investors wanted to be truly passive, they would put their money in a total stock market index — arguably the most accurate measure of “the market.” Similarly, a portfolio of index funds that provide a risk and return profile that mirrors the broad market is another example.

But only about 21% of index fund assets were held in total-market strategies at the end of 2020, according to a paper published in the Journal of Beta Investment Strategies. If you loosen your definition of “the market” to the S&P 500 index of large-cap stocks, funds tracking that benchmark represented less than half of the $4.8 trillion invested in index funds other than total stock market strategies as of Dec. 31, 2020.

In addition, most index funds don’t track “the market”; they have risk and return profiles more akin to active managers.

In fact, index funds based on elements other than just market cap deviated, on average, by 22 basis points from the Dow Jones U.S. Total Stock Market Index between August 2009 and December 2020, the report shows. That compares with a mean monthly tracking error of 40 bps for active funds. And the average monthly returns on non-total-market index fund underperformed “the market” by a margin even bigger than the average performance active funds in the post-crisis period: -5 bps to -2 bps.

Vanguard’s conclusion in this data is that the average portfolio of index funds looks and performs substantially different than the total market, which indicates there are active bets involved.

To be sure, the approach is different than making bets on which manager’s approach to analyzing stocks is superior, or at least in the moment.

But advisors can still position their decisions about how to allocate money across the various slices of stocks— large versus small, value versus growth, consumer cyclicals versus consumer staples, high dividend payers versus low ones —as active management based on their understanding of a client’s needs. Index ETFs serve as great building blocks, but it’s up to advisors to show clients that their engineering skills are worth the fees they charge.

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