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A new form of active?

Commentary by James J. Rowley Jr., CFA

In my role as Global Head of Investor Research, I enjoy participating in various industry conferences, policy forums, and client engagements. Over the past few years, I’m frequently asked at these events about “the trend toward passive.” This is a natural question given the level of industry discussion and commentary on the topic. These perspectives often cite stats and offer views on the investor dynamics underlying this trend. Regardless of the forum I’m speaking in, I find the audience is sometimes surprised to hear my headline perspective: I believe the trend reflects a new form of active investing, not passive! 

This response is often met with inquisitive—and sometimes confused—looks, so allow me to explain. As a researcher, I scrutinize data and assess situations through a variety of lenses. Discussions about the trend toward passive tend to be prompted by the increased market share of index funds relative to that of traditional active funds. And while I would agree that it is best to assess the trend based on aggregate assets, I find this perspective to be a bit limited because it provides insights about individual fund use based on a category (i.e., index or active) that is not highly indicative of investment exposure. To put it simply, the notion overlooks a much more critical perspective—the aggregate investment exposure at the portfolio level. 

I’ll use the same extreme example that I use while responding to audience questions to illustrate this point. Suppose an investor states she is “100% passive” because she implements her entire U.S. equity strategy with a small-cap value index fund. Although that might be a 100% allocation to a passive fund, it is not a 100% passive position. Using a small-cap value index fund to implement an allocation to the total U.S. equity market is a highly active position. Whether this is intentional or unintentional isn’t the point, but it would reflect an active allocation.

This chart illustrates my reasoning. If investors aimed to implement a truly passive strategy relative to the total U.S. equity market, they would likely just use funds that have an objective of doing so (noted in the chart as “total market index funds”). However, most of the growth in index fund assets has been driven by investors selecting funds that do not have such an objective (“non-total market index funds”). Investors might be using more and more index funds, but they aren’t building truly passive portfolios.

Non-total market index funds capture the majority of index fund assets 

Notes: The chart shows the development of assets under management in the categories of non-total market index funds, total market index funds, and active funds. Time period observed: January 1995 to December 2020.

Sources: Vanguard calculations, based on data from Morningstar, Inc.

To address this trend, my colleagues and I contributed new research to The Journal of Beta Investment Strategies called “How Investors Use Passive for Active.” We provide detailed evidence that non-total market index fund investors seem to be active in nature. Technically speaking, we find nontrivial variability of excess returns relative to the total U.S. equity market, statistically significant style factor exposures, and industry-level asset weights that are not market-capitalization-proportional to the total U.S. equity market. Casually speaking, it just means that the aggregate portfolio of index funds isn’t passive relative to the market—it’s active.

In addition to making explicit the phenomenon that investors are using passive funds to build active portfolios, our research underscores the importance of analyzing investment strategies as opposed to relying on categorical labels such as “index” or “active.” So the next time you’re engaged in a conversation about “the trend toward passive,” you too can offer your audience a different lens: At its core, this may very well be a trend in active investing. 


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