By: Phil Kernen

Active or passive? We are all active investors, but some don’t know it yet.

Recently Vanguard published a paper in the Journal of BETA Investment Strategies to explore how investors use index funds to build portfolios. It found that they are actively using index funds. To reach the conclusions in the report, Vanguard divided the fund universe into three groups.

  • Active Funds (Group A) – just as it sounds, active funds direct investments through human managers’ decisions.
  • Total Market Index Funds (Group B) – reflective of the original idea behind passive investing, these funds inexpensively replicate widely diversified total market indexes like the Wilshire 5000 Index, the Dow Jones U.S. Total Stock Market Index, or the Russell 3000 Index.
  • Non Total Market Index Funds (Group C) – funds that are neither actively managed nor designed to replicate total market indexes. Instead, these funds replicate sub-asset class indexes such as value or small company stocks.

Vanguard constructed portfolios for each group proportional to each fund’s assets under management. A review of the universe based on these groupings reveals previously unrecognized trends in the growth of index investments.

  • Growth in index funds overall since 2009 has been driven mainly by Group C, whose assets under management had grown nearly as large as Group A. Group B funds are growing much more slowly. By 2020, one dollar went to Group B and four dollars to Group C for every five new dollars invested in index funds.
  • Within Group C, the researchers identified funds whose objective is to track the S&P500, a large-capitalization company index, because it is so well known. They discovered that until 2009 S&P 500 funds routinely gathered more than 50% of new investments in Group C. After 2009, it moved below 50% and continued to decline, leading to two review periods for the research.

These data points suggest that investors using index funds have gone away from seeking total market exposures and towards more targeted index funds. Most investors who use index funds aren’t buying ‘the market.’ They use index funds to make independent decisions about portfolio construction and attendant risks and likely returns that differ from the market. Further observations reinforce their conclusions.

Tracking Error

Vanguard reviewed the performance of each of these groups, comparing them to the Dow Jones Total Stock Market (DJTSM) Index. Tracking error measures the divergence between the price behavior of each group and the price behavior of a benchmark. As you would expect, Group B tracked the DJTSM very closely. The tracking error of Group C was material reflecting aggregate decisions moving away from total market exposures.

Factor exposures

Vanguard dug further and discovered that different exposures, or factors, explain the tracking error for Group C. In the first period to 2009, Group C had greater relative exposure to large companies, higher beta companies (greater sensitivity to market price changes), and greater relative exposure to value companies. By the second period, Group C funds had reduced exposure to large and high beta companies, favoring smaller companies and specific sector exposures instead.


If investors used index funds primarily to build passive portfolios with total market exposures, we would expect the weighted aggregate of all index funds to be equal to the total market. We would also expect the weighted aggregate sub-asset index funds and industry allocations to equal the comparable subsets of the total market. Group B matched expectations, but Group C did not. The magnitude and consistency of the variations differed by industry. However, two examples of long-standing deviations from the DJTSM include an overweight in real estate and underweight in financial services.

Too many investors labor under the fiction that using index funds means passively obtaining total market exposure in their portfolio. Research shows that is not the case and the majority of investors using index funds are just as active as the rest of us.

Disclosure: This is for informational purposes only and any reference to a specific type of security does not constitute a recommendation to buy or sell that security. The reader should not assume that an investment in the security identified or described, was or will, be profitable.    For a complete list of disclosures, please click