1.2.1 What Is Active Investing?

Active investing is a strategy that investors use when trying to beat a market or appropriate benchmark. Active investors commonly engage in picking stocks, times, managers, or styles. As later steps demonstrate, active investors who claim to outperform a market also claim the power to predict the future. When accurately measured, this is simply not possible. Surprisingly, the analytical techniques that active investors use can best be described as qualitative or speculative. They include predictions of future sales and earnings growth, and are often based on gut feelings and intuition. On the other hand, the passive index investing approach is best described as quantitative or scientific. Indexing techniques include statistical analysis of risk and return data of 20 years or more, in addition to extensive measurements of numerous performance criteria. Many indexes are now based on 75 years of risk, return, and correlation data.

1.2.2 What Is Index Funds Investing?

As opposed to active managers, investment managers of index funds are far less active in the buying and selling of stocks, because they do not pick stocks or managers, time markets, pick styles, or make attempts to forecast the future. As previously mentioned, the analytical techniques that index funds managers use are best described as quantitative or scientific.

Approximately 15% of all individual assets and 44% of all institutional assets are currently invested in different index funds. Many institutional funds are one hundred percent indexed. Even Charles Schwab and Company recommends that investors put 80% of their large cap assets into index funds. Mr. Schwab himself has 75% of his mutual funds in index funds. Other indexing proponents include Barclay's Global Investors, Dimensional Fund Advisors, The Vanguard Group, Warren Buffet, Peter Lynch, numerous academic institutions, Economic Nobel Laureates, and Index Funds Advisors (IFA). Insurance companies use a similar approach to indexing when setting premiums for the risks taken by insuring against thousands of different random events. Most of those premiums are also invested in index funds while held in reserves for the inevitable claim payment.

Most investors believe that index funds investing means investing in familiar market indexes, such as the Standard and Poor's 500. S&P 500 funds are structured with the aim to provide the same investment performance as the S&P. By holding all the stocks in the same proportionate amounts as the S&P index, the fund index represents about 86% of the market value of all U.S. companies, mostly large blue chip stocks. The problem is that market indexes, such as the S&P 500, were not originally designed as investment vehicles.

Since the late 1980’s, index funds have expanded and are based on more discrete customized indexes. Originally designed for very large pension funds, institutional-style index funds are meant to capture various financial risk factors or dimensions of the market. Exposure to a risk factor such as company size or value constitutes a risk dimension of the market. Investors have been compensated with higher returns for risk exposure to these risk factors since 1929. These dimensions of the market can also be referred to as indexes. Indexes are groups of stocks that have common risk and return characteristics and comply to specific and clearly defined sets of rules of ownership. These groups of stocks include companies from the United States, foreign companies, and even emerging markets. There are additional indexes within these markets, such as value, large value, small growth, large growth, real estate securities, and many fixed-income investments, such as short-term and long-term treasury bonds, municipal bonds, and corporate bonds. Companies are purchased and held within the index when they meet the index parameters. Stocks are sold when they move outside of these parameters and no longer meet the index rules.

An example of an index fund is Dimensional Fund Advisors' (DFA) Micro-Cap index fund, which invests in securities of U.S. companies whose size (market capitalization) falls within the smallest 4% of the total market universe. This includes all stocks traded on the New York Stock Exchange and the American Stock Exchange, as well as those listed in the National Association of Securities Dealers Automated Quotation Over-the-counter (NASDAQ OTC) market. Another example would be DFA’s Small Cap Value Fund, which invests in companies ranked in the lowest eight percent by size, as well as the highest 25th percentile by book-to-market ratio (value).

DFA funds are now available to individual investors through a small qualified group of registered investment advisors who have demonstrated their understanding and commitment to the concepts described in this 12-Step Program.

The overwhelming majority of investors are active investors. Extensive research by many academics and investment professionals has shown that investors cannot beat a market in the long run with stock, time, manager, or style picking. It is disconcerting that about seventy percent of all institutional money invested in U.S. stocks is still actively managed.

1.2.3 Comparison Table

The table below summarizes the differences between the two approaches to investing.