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Indexing is Not Passive


Index investing has become more popular in recent years. For example, someone can hold an index fund that tracks the S&P 500 index for an extremely low fee.

Index ETFs (or index funds in general) are often called "passive", whereas mutual funds that use fund managers are called "active". This terminology implies that mutual fund managers make various decisions about their portfolios, while index funds do not. It's implied that index funds hold static, unchanging portfolios and do not apply any intelligence.

Critics of indexing complain that the lack of intelligence or human decision-making results in a number of problems. One supposed problem is that indexes hold a large number of poor stocks, since they lack the human intelligence to weed them out. Another frequently-cited problem is that indexes distort market prices, since anyone following the index is blindly and indiscriminately buying everything.

But are the indexes really so passive?

A key assumption of the critics is that indexes are dumb, static portfolios that have no human decision-making / management.

But this is not necessarily true. Here are some recent examples of active management in the major indices:

Changes to the indices are often unpredictable. The changes are either decided by humans, or by some computer algorithm which capture the decision process of humans. In either case, I think it's fair to say these are human-driven decisions.

Most of the changes appear to be sensible, too. You will often see weak or terrible stocks eliminated, and replaced with new promising ones.

How is that different from an actively-managed fund?

What index funds REALLY are

In my view, indexes offer lightweight active management, where the management is outsourced to the index providers.

Contrary to popular belief, index funds are still actively managed. However, there is minimal intervention. The fund managers apply a very light touch, mostly leaving positions alone. This is especially true for cap-weighted indexes, since the positions naturally grow or shrink based on the underlying equities.

The fund managers still exist. In the case of the major S&P indices, there is a committee of people who decide what to add and remove on a regular basis. This is portfolio management, and it involves judgement calls.

An index fund or ETF which tracks the index is outsourcing their fund management to this committee. The index does not blindly hold a portfolio of stocks.

Additional resources:

Jem Berkes