Leveling the Playing Field

Passive investing has democratized market access.

Index-based, or “passive,” investing occurs through investments in index-linked products such as index mutual funds, ETFs, and options contracts. Passive investing may offer the following beneficial characteristics:

Diversification

Transparency

Market Return

Cost Efficiency

Introduction to Passive Investing

A radical idea when John Bogle launched the first index mutual fund in 1976, index-based/passive investing has revolutionized the way investors access financial markets and participate in market performance.

There are good reasons for index-based investing’s unique appeal. It can provide portfolio diversification and transparency, so investors may know what is owned. Thanks to the variety of index-linked products, investors can participate in a wide range of large and small financial markets around the world. It’s possible to build a portfolio of index-linked products with widely varying objectives, investment styles, and/or risk tolerances.

The risks taken, as well as the returns realized, will correspond to the risks and returns of the markets in which one invests. However, it should be noted that index returns do not reflect expenses investors would pay to purchase or hold index-based products. That said, index-based investing is often less costly than actively managed investing.

But what, exactly, is index-based investing (sometimes called “passive investing”)? It’s not, as the term may imply, investing directly in an index. That’s because an index isn’t an investment. It is a measure of securities or other assets in a specific market. Indices can and do serve as the basis for investment products, such as index mutual funds, exchange-traded funds (ETFs), and options contracts.

The index to which an index product is linked determines that product’s portfolio. For example, an ETF linked to the Dow Jones Industrial Average® holds the 30 stocks in that index and seeks to match its performance. That’s the fundamental difference between index-based investing and active management. Using an active approach, managers subjectively select securities in an attempt to beat their benchmark indices.

Passive investing has two chief advantages over active management:

Cost

It’s typically expensive to compensate active managers and to pay for the frequent trading costs of their buy-and-sell decisions.

Results

Most active managers fail to outperform the market over the long term.

Key Moments
in Passive Investing

Diversification

A diversified portfolio holds a large number of securities that react differently to changes in the economy or market environment.

For example, some stocks typically outperform the broader market when the economy is booming, but underperform when it slows down. The value of other securities may not be seriously hurt by a downturn or boosted by an upturn. A diversified equity portfolio holds some of each.

As a result, diversification typically provides greater protection against market risk than owning a limited number of stocks or other securities. When a portfolio is sufficiently diversified, assets that are strong at any given time can help offset losses in those that may be losing value. The more diversification there is, the greater the potential mitigation of risk in the event of market loss.

The impact of diversification, which is the foundation of modern portfolio theory, was explained by the Nobel Prize-winning economist Harry Markowitz. He concluded that the “perfect portfolio” was the whole stock market because it provided the greatest diversification. But until Vanguard opened the first index fund more than 20 years after Markowitz’s groundbreaking work, it just wasn’t feasible for individual investors to attain such market diversification.

Today, a portfolio of index-linked products can provide exposure to broad markets either locally or globally. This means investors can come very close to owning the portfolio that Markowitz described. Even within a more narrowly defined market, such as an industry or sector, some investors use diversified index products to lower risks relative to investing in individual securities.

  • Fathers of indexing:

Harry Markowitz

Transparency

An ETF or index-linked mutual fund seeks to replicate the performance of the market its underlying index tracks, by owning either all the securities in that index or a representative sample.

Risk that the ETF or fund will stray far from its stated objective is limited. That can happen, however, with an actively managed fund if the fund buys stocks that aren’t consistent with its investment approach, but are selected to bolster its return. The result of this approach, described as style drift, may expose an investor to more risk than they’re comfortable taking or to less risk than they’re willing to assume to meet investment goals.

Transparency means knowing not only what a fund owns but also in what proportion. With index investments, this information is typically publicly available every day. Actively managed funds, on the other hand, are required to report their holdings just four times a year. Between quarterly filings, these funds can hold any securities and in any proportion, so it’s entirely possible for funds with very different objectives to own a number of the same securities, especially current strong performers, without ever making that information public. For an investor, this can result in duplicative holdings and loss of diversification, which increases investment risk.

Market Return

Indices are designed to mirror the risk and return characteristics of the markets they measure through a representative sample of the underlying assets.

Index-linked investment products, therefore, can be a convenient means of capturing specific market performance. What’s more, it’s widely recognized that securities markets, especially those in developed economies, are highly efficient.

Ultimately, market efficiency means that there are few opportunities to exploit information that may impact the behavior of individual securities or the broader markets. This information is already priced into the markets and is reflected in the performance of indices and the index-linked products that track them.

What makes a market efficient?

01
Existing market information is readily and inexpensively available and incorporated in security prices.
02
New information about a security occurs randomly and is thus unpredictable.
03
The effect of any new information on a security’s price is equally unpredictable.

Of course, no investment strategy, including a passive approach, guarantees a positive return. But a well-diversified portfolio has historically risen over the long term. U.S. equity prices, for example, have maintained an upward trend as demonstrated by the historical performance of the S&P 500® and The Dow®. Index-based investing is an approach designed to help investors capture this market return.

Cost Efficiency

The price paid to buy and own an investment reduces its potential return. The higher the investment cost, the greater its drag on performance.

Two key measures of investment cost are expense ratios and trading costs. An expense ratio is the amount, expressed as a percentage of the account’s value, that is regularly subtracted from its return to cover fees for administration and investment management. Trading costs are the fees that a fund pays to buy and sell securities for its portfolio. An expense ratio is public information. It can be found in an investment’s prospectus, in a variety of online sources, and in the financial press.

Find out how the costs of active and passive funds differ.

Given the passive nature of index-based investments, index funds and ETFs tend to have lower expense ratios than actively managed funds. In 2019, for example, actively managed equity funds had, on average, an average expense ratio of 0.74% while the comparable expense ratio for equity index funds was only 0.07% (Source: ICI. Based on asset-weighted averages). Expense ratios do vary by investment objective, however, and are often higher for small-cap funds, international funds, and those with more specialized objectives. It’s often more costly to own an actively managed investment with a particular objective than a passive investment with the same objective.

One reason for this difference in cost may be that compensation of passive managers tends to be less than that of active managers. In addition, there’s more money in the average equity index fund (USD 8.4 billion) than in the average actively managed equity mutual fund (USD 1.9 billion), and economies of scale help to reduce costs. (Source: ICI. Data as of year-end 2019.)

Trading fees, another contributor to investment cost, are not included in a fund’s expense ratio or reported separately. To estimate what a fund spends on trading, its turnover rate must be known. That’s the percentage of the fund’s portfolio that’s replaced during a year. The greater the turnover, the higher the trading costs. On average, the turnover rate for an equity mutual fund in 2019 was 28% (Source: ICI). A fund that turns over half or more of its portfolio in the course of a year is likely to generate substantial short-term gains, with resulting tax consequences.

Index funds and ETFs tend to turn over their portfolios only when there is a change in the underlying index—sometimes just a few times a year or even less frequently. In fact, many indices are constructed specifically to limit turnover.

Eugene Fama—the Nobel Prize winner often described as the father of index investing—pointed out that this combination of factors makes it extremely difficult, if not impossible, for active managers to outperform an efficient market or the indices that track it. According to Fama, to gain any advantage in securities selection, managers would have to predict correctly, over and over again, what new information might emerge about a security and how the security’s price might be affected as a result. Years of statistics generated by S&P Indices Versus Active Funds (SPIVA®) studies confirm the challenge active managers face. Few active managers have outperformed their relevant benchmark index in any given year, and virtually none have done it consistently.

  • Fathers of indexing:

Eugene Fama

Index-Linked Products

Despite their wide popularity today, index-linked products are a recent addition to the investment landscape.

In his groundbreaking guide to investing, A Random Walk Down Wall Street, first published in 1973, Burton Malkiel argued for the creation of a no-load, low-fee mutual fund. This type of fund would give investors access to market return, or beta, by buying the component stocks of a market index and making no effort to outperform the index.

  • Fathers of indexing:

Burton Malkiel

  • Fathers of indexing:

John Bogle

  • Fathers of indexing:

Burton Malkiel

Just three years later, in 1976, Bogle’s index fund was launched, providing what he described as broad diversification at relatively low cost. ETFs followed in 1993, adding more trading flexibility, greater tax efficiency, and a larger opportunity set covering a wide range of investment strategies.

  • Fathers of indexing:

John Bogle

As evidence of the increased popularity of index products, as of 2019, U.S. investors had about USD 4.3 trillion invested in index mutual funds, and more than USD 4.4 trillion in ETFs (Source: ICI, 2020).

The universe of index products was also enlarged by the introduction of index-linked futures contracts in 1982 and options contracts in 1983. These products, while different from each other in some important ways, are used to:

Hedge an equity
or bond portfolio

Generate
income

Gain broad
market exposure

Unlike ETFs and index mutual funds, these index futures and options do not tend to be buy-and-hold investments. Understanding how to best leverage these approaches requires an understanding of an investor’s goals, timeframe, and an analysis of a myriad of strategies designed to potentially achieve the stated investment objective, combined with timely action.

Index Product Applications

Core-satellite

Some investors may use ETFs and index funds that track broad market segments as the building blocks of a core portfolio. They pick and choose from these index-based products to create specific allocations.

Selections may also be altered to shift the balance between risk and return in response to life events or changing goals. Index-based products are used to add short-term exposure to a specific sector, country, region, or strategy—a process typically described as attaching satellites to the core.

Index inside

Financial advisors may use an index-based approach, constructing a diversified portfolio of index funds and ETFs. These investments are likely to be institutional products, not directly available to individual investors. But this “index inside active” approach is used to provide market return without only attempting to outperform.

  1. William F Sharpe, “The Arithmetic of Active Management,” in the Financial Analysts’ Journal, 1991.
  2. SPIVA U.S. Scorecard, 2013, bullet # 2 (reaffirmed in more recent SPIVA results and frequently cited).
  3. Markowitz: Harry Markowitz, “Portfolio Selection,” in Journal of Finance, 1952.
  4. Vanguard fund: The fund opened in 1976. The point that individual investors had no access to a broadly diversified portfolio before the Vanguard fund is made in Burton Malkiel’s "A Random Walk Down Wall Street," now in 11th edition, originally published 1973.
  5. Interviews with members of the Index Committee, including David Blitzer, Craig Lazarra, and others in January 2014.
  6. Eugene Fama: Eugene Fama, “The Behavior of Stock Prices,” rewritten as “Random Walks in Stock Market Prices,” in Financial Analysts’ Journal, 1965, and in “Efficient Capital Markets: A Review of Theory and Empirical Work,” in Journal of Finance, 1970.

You’ve completed Chapter 4.

Now, test your knowledge by taking a brief quiz.

01 Which of the following statements about index-based investing is false?
02 A broadly diversified portfolio provides:
03 What is passive investing?
04 Which of the following is not a characteristic of efficient markets?
05 An advocate for passive investing might argue that:
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