Written by: Tricia Rosen, CFP®, MBA, EA, Principal of Access Financial Planning, LLC

The Unexpected Downside of Passive Index Investing

Index funds are more popular than ever, with lots of good reasons for it. However, the downside of passive index investing can catch investors by surprise because they can adversely impact your portfolio in ways that you wouldn’t expect.  A blending of traditional passive index funds with a touch of active management hits the sweet spot of optimal return with appropriate risk for most investors.

The Start of Index Investing

Index investing began in 1975 when Vanguard’s founder, Jack Bogle, came up with the radical idea that buying and holding the broad stock market would provide better results than trying to beat it by picking individual stocks. The Vanguard 500 was called “Bogle’s Folly” by skeptics and was dismissed by many as a recipe for average results and a subpar way to invest. Time has proven that investing in an index fund has led to more favorable returns for most investors than active management. It’s a cost effective way to get portfolio diversification without the additional risk associated with active management strategies. But the devil is in the details on why this is the case. The term “index investing” is very broad and has several pitfalls that investors need to take into consideration to avoid the downside of passive index investing.

What Are Index Funds?

An index fund is an investment fund that seeks to replicate the performance of a specific financial market index such as the S&P 500. The index fund will mirror the holdings and returns of the index it tracks. In contrast, actively managed funds instead select individual assets which the portfolio manager believes are advantageous to hold in the portfolio. An active portfolio manager strives to beat a representative index instead of matching it.

An index fund is most often either an exchange traded fund, known as an ETF, or a mutual fund. ETFs have gained popularity over mutual funds due to their lower expense ratio, intra-day liquidity, and tax efficiency. However, both ETFs and mutual funds are publicly traded and can be purchased or sold easily by investors.

Upside of Index Investing

There are advantages of index investing which have led to it’s popularity, especially in comparison to the risks and expenses associated with active investment management strategies. Two of the most significant advantages are performance related and expense ratio related.

Performance for Index Funds

Index funds are popular among investors who believe in an efficient market hypothesis which states that most if not all information about a company’s performance is already imbedded in the stock price. The belief is that it is nearly impossible to out-perform the market for publicly traded securities unless you are participating in insider trading schemes or you have unusually good luck. However, insider trading schemes are illegal, as Martha Stewart knows, and good luck is impossible to control or replicate reliably.

Trying to time the market, or selling and buying securities in order to try to profit from the transaction, has been proven in several industry studies to adversely impact a portfolio’s performance. Even if someone gets it right on when to buy or sell a security initially, getting it right twice and knowing when to reverse the first investment decision has even lower odds of success. The investing discipline associated with index investing prevents market timing mistakes which are common with active management.

Lower Expense Ratio

The primary advantage of the index funds is their low expense ratio compared to actively managed funds because they require less frequent trading and less investment management research. The additional cost associated with active management eats into the portfolio performance, making it even harder for active management strategies to outperform more passive investment strategies. Some popular index ETF’s have expense ratios as low as 2 basis points, which is 0.02% of the assets. In comparison, actively managed mutual funds have an average expense ratio of 75 basis points or 0.75% of assets.

What Does Passive Investment Mean?

Passive investment means following a rigid set of guidelines and not allowing for human judgement to make decisions on the portfolio holdings. Index investing is a type of passive investing and means the portfolio holdings will mirror a specific index.

Downside of Passive Index Investing

Passive investment management is preferred by many investors, especially if you fundamentally believe in efficient markets and want to keep expenses as low as possible. However, there are some significant costs associated with passive investment management that aren’t obvious and can be very impactful to the overall performance of the portfolio.

Hidden Expenses

In order to be consistently representative of the index they track, an index fund must change, referred to as reconstituted, periodically. The downside impact of reconstitution can ripple through portfolios in the form of high trading costs, tax implications, and shifting market exposure.

Passively managed index funds must buy the index additions and sell the deletions at the same time as the reconstitution occurs for the benchmark index so that the tracking error of their fund remains low. The resulting frenzy of trading that follows reconstitution is highly visible and well anticipated in the market. For the many ETFs and mutual funds that attempt to replicate the index as closely as possible, they will be trading during an avalanche of forced trading all on the same day. As a result, index funds and market-cap-weighted ETFs are forced to buy high and sell low. Furthermore, the trading costs due to commissions and other expenses that stem from all this activity is passed on to fund shareholders. However, neither of these costs are reflected in the fund’s expense ratio which can be misleading when investors are comparing investment choices.

As an example, in July 2023 the Nasdaq 100 Index underwent a reconstitution to trim weight in Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla. The combined weight of these stocks was reduced from 55.4% to 42.9% and the proceeds were reinvested among the rest of the index’s holdings. These changes became effective July 21, meaning index fund managers minimizing tracking error had to align with the new index composition by the end of that trading day. The demand for trades in securities which were impacted the changes was up 500% on the reconstitution date compared to the surrounding days. Sort of like when Taylor Swift concert tickets go on sale.

Hidden Active Management

Another downside of passive index investing is there technically is no such thing as a truly passive mutual fund or ETF. An investment decision is still being made in a passive index fund because a decision is being made to follow a specific index. What matters most for investors is the guiding framework driving these investment decisions. Is the focus on increasing an investor’s return with an appropriate amount of risk or volatility, or is it on satisfying constraints to rigidly follow an index? Rigidly following an index and not allowing the portfolio manager to use known facts to better position the portfolio with minimal risk isn’t providing the best value for the investor.

The benchmark index which is being followed by the fund is very important and not given appropriate consideration by many investors. For example, there have been many new index funds which track obscure, narrowly focused indexes such as corn, Andean companies or lithium miners. They are still passive index funds, but they have high investment performance risk because they are less diversified. There also has been an explosion of leveraged indexed funds that promise 2 times the return or the inverse of their benchmarks. Niche index funds are in reality a bet on a market segment, which is active management. They burn unaware investors who buy them without understanding them or who unsuccessfully use them to make short-term market timing bets.

A Blend of Passive and Active Management

Not all index fund portfolio managers are held to the same rigidity in their investment management decisions. There are some funds which follow an index but allow the portfolio manager to have some tracking errors and deviations from the index. This allows the portfolio manager to trade more intelligently around reconstitution events and allows for other portfolio management decisions which take into account macro-economic or geo-political events without crossing over into the detrimental aspects of active management. Funds which follow an index but with more flexibility allowed are often referred to as smart beta or factor tilt funds.

Smart Beta

Smart Beta is a name given to funds which generally follow an index, but the portfolio manager has some discretion and isn’t bound to keep the tracking error as low as possible. The term beta is a statistical term used in investing to indicate a stock’s volatility as compared to it’s market benchmark. A beta of 1.0 would mean an investment has the same amount of volatility as the broad market benchmark. A beta of 2.0 would mean the investment is twice as volatile as the broad market. A passive index fund would strive for a beta of 1.0.

A smart beta fund would strive to increase the investment’s beta, but only in a way that made sense, or was a smart beta increase. Smart beta emphasizes capturing market inefficiencies in a rules-based and transparent way as opposed to trying to identify the next unicorn before anyone else does. The additional volatility is acceptable because of the corresponding increase in portfolio performance and is much less volatile than pure active management would be.

Factor Tilt

Factor tilt is similar to smart beta in that the portfolio manager will start with a portfolio which resembles an index fund, but will then make changes to the holdings using rules-based strategies which have been shown through extensive research to be correlated with higher expected returns. The weighting of the holdings in the portfolio will be titled to favor the factors of expected higher returns. The tilt can be slight, or it can be more aggressive, depending on the stated mandate for the portfolio. Portfolios that target multiple dimensions of expected returns, rely on several sources of added value, and are executed efficiently have been shown to provide more value than passive index investing.

Various portfolio managers may use different factors when they are managing factor tilt funds, and some are more reliable than others. The factors used by Dimensional Fund Advisors, a leader in the factor tilt fund space, are company size, value pricing, company profitability, and price momentum. Dimensional will take into consideration the price investors are currently willing to pay for the expected return associated with the factors when making the determination for how to implement the factors in a portfolio, and therefore can avoid the higher transaction costs associated with a reconstitution date, for example.

To Tilt or Not To Tilt

Whether a smart beta or a factor tilt portfolio is an appropriate approach for an investor is driven by that individual’s sensitivity to deviations from the benchmark market indices. There are also funds which are called smart beta or factor tilt funds which are based on drivers of returns which are not well documented over time, so buyer beware. Don’t rely only on the fund name when choosing an ETF or mutual fund. Look underneath the hood to see what is really going on in the fund because sometimes the fund names can be obscure at best and misleading at worst.

Well established and well run smart beta or factor tilt ETFs and mutual funds include a lot of the benefits of index-based approaches to investing such as diversification and low cost, but they don’t suffer from the drawbacks of passive investing due to investment management inflexibility. Using smart beta or factor tilt funds in a portfolio can add positive performance returns with minimal additional volatility. Almost as awesome as getting Taylor Swift concert tickets!

Downside of Passive Index Investing

Most investors are unfamiliar with what they are choosing for investments and rely on information from well-meaning friends or colleagues, which may not be accurate and may not be appropriate for your unique situation. As with most things, buyer beware! Passive index investing is better than some alternatives, but may not be your most advantageous choice.


Additional Information: 

As always, if you would like more information on index investing, the downside of passive index investing, or any other financial planning topic, please contact me. Find out more about Access Financial Planning, LLC here

Disclaimer: This article is provided for general information and illustrations purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult with a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Tricia Rosen, and all rights are reserved. Read the full disclaimer.