“Investors often use index funds to build active exposures,” said Plagge, the head of active-passive portfolio research at Vanguard. “They do this by investing in index funds whose objective is to track an index that is a subset of an equity market. To the extent that these building blocks are not weighted in proportion to the market capitalization of their holdings, the aggregate index fund portfolio bears active risk.”

And the nature of active risk that investors take changes over time, depending on investors preferences. Plagge said that over the last decade, investors’ use of “non-total market index funds” has moved beyond those that predominantly focus on the largest stocks of a given market, such as funds based on the Standard & Poor’s 500 Index to those that focus on a wider range of other segments of the market.

To illustrate the active nature of non-total market index funds, the study offers several empirical analyses, including a review of relative returns through time, an analysis of factor-based styles, and an analysis of industry allocations.

The authors compare the performance of three constructed aggregate portfolios (non-total market index funds, active funds, and total market index funds) to that of the Dow Jones Total Stock Market Index over two time periods (1995–2009 and 2009–2020). Non-total market index funds are those index funds that do not track a total U.S. equity market index. Total market index funds are defined as those that have the objective to track a total U.S. equity market index. Active funds are traditional actively managed funds. The performance of each of the three derived portfolios is calculated as the asset-weighted average of all U.S. equity funds that fall into the respective category.

As expected, the aggregate of total market index funds closely tracks the Dow Jones index, while the returns of the aggregate of active funds differ noticeably from those of the index. But what’s important to note is how much the performance of the aggregate of non-total market index funds diverges from that of the market. Although the level of deviation is not as high as that of active funds, it is clearly higher than that of the total market index funds.

The authors also test whether systematic style exposures might have caused the monthly return deviations of the aggregate of non-total market index funds from the total market index. Their models suggest that systematic factors do explain a noticeable portion of the variability of returns.

Their results showed that, in fact, parts of these return deviations were driven by systematic style exposures. These exposures changed over time, indicating the changing choices made by investors. During the first time period (1995–2009), investors made choices that resulted in an aggregate portfolio of relatively higher beta stocks,¹ larger-cap stocks, and value stocks while in the second period (2009–2020), the aggregate investor portfolio consisted of relatively lower-beta stocks and smaller-cap stocks. This shift is another indication that, for many investors, their investment exposure in non-total market index funds is active in nature.

It stands to reason that if investors choose index funds to build truly passive portfolios, the asset-weighted aggregate of all index funds should equal the total market, and every cross-section should be proportional to the comparable subset of the total market.

But that doesn’t hold up. The active nature of the aggregate of non-total market index funds also manifests itself in industry weights that are not aligned with those of the broader U.S. equity market. The magnitude and consistency of the deviations differ by industry. To be clear, no industry was found to have been either underweighted or overweighted over the entire time period. However, deviations were more stable for some industries. For example, real estate has been overweight in 233 out of 313 months observed, while financial services has been underweight in 279 of the 313 months.

The study’s results suggest that investors are using non-total market index funds to construct portfolios with active exposures. This conclusion rests on three observations linked to the asset weighted aggregate of non-total market index funds: the existence and variability of excess returns relative to the total U.S. equity market, significant exposures to style factors such as size and value, and industry allocations that are not identical to those of the total U.S. equity market.

“Our observations are important for two reasons,” said Wang, a portfolio manager in Vanguard Quantitative Equity Group. “They stress the importance of analyzing strategies as opposed to whether a fund is active or index, and they illustrate the active use that investors make of passive strategies.” 

• “Investors might be using more and more index funds, but they aren’t building truly passive portfolios.” Our head of investor research explains in A new form of active investing? (Published March 2022)