Updated: May 15, 2026  |  Originally Published: January 2025

For decades, the investment world operated on a comfortable binary: funds were either active or passive, and everyone knew which was which. Active managers picked stocks. Index funds tracked benchmarks. The line was clean.

That line has all but disappeared.

Today, a fund can be labeled "active" by Morningstar and still operate without a single discretionary security selection decision. A fund can call itself an "index fund" while tilting heavily toward factors that academic research has identified as drivers of higher expected returns. And a new category called direct indexing has emerged that is neither a fund in the traditional sense nor purely passive — yet it behaves like both.

The question "What really is an index fund?" now requires a broader discussion. That discussion will impact how you evaluate, compare, and ultimately select investments.

At IFA, we define index funds as mutual funds or exchange-traded funds that follow a set of rules of ownership which, under normal circumstances, are held constant. That definition is intentionally broad — and deliberately so. It captures both the traditional S&P 500 tracker and the more sophisticated systematic strategies that have emerged over the past four decades.

The SEC offers a useful starting framework. In its Investor Bulletin on non-traditional index funds, the agency divides the index fund universe into two categories: traditional index funds, which track established market indexes like the S&P 500 or Russell 2000, and non-traditional index funds, which track custom-built indexes (such as Dimensional or WisdomTree Indexes), constructed using criteria such as factors, quantitative methods, or environmental, social, and governance (ESG) screens. The SEC notes that while non-traditional index funds are still considered "passively managed" — because the adviser seeks to track an index rather than exercise independent judgment security by security — they use very different strategies than their traditional counterparts and carry unique risks around complexity, correlation, and cost that investors must understand before investing. Notably, many of these custom indexes are not published to the public.

That two-part taxonomy is a reasonable starting point. But as we will show, even it no longer captures the full picture.

The Original Distinction and Why It Made Sense

When John Bogle launched the first index mutual fund for retail investors in 1976, the definition was simple: replicate the S&P 500, hold everything in proportion to market capitalization, trade as little as possible, and charge almost nothing. Passive meant rule-based, low-cost, and market-cap-weighted, even though a committee at Standard and Poor's selected the stocks that they thought best represented an industry.

Active meant the opposite: a manager used research, judgment, and conviction to assemble a portfolio designed to outperform that benchmark. Higher costs were accepted as the price of that expertise. Active also means that an investor seeks to identify mispriced securities (under or overvalued), as opposed to accepting that all securities generally reflect available information in market prices, which is a central premise of Eugene Fama's Efficient Market Hypothesis.

The case for indexing rested on three pillars:

1. Markets are largely efficient. Prices reflect available information quickly and are therefore fairly priced, making consistent outperformance through the selection of mispriced securities extremely difficult.
2. Costs compound against active investors. Every dollar paid in management fees and trading costs is a dollar not compounding in the portfolio.
3. The arithmetic of active management is unforgiving. Before costs, active managers as a group must equal the market return — because they are the market. After costs, they must lag it.

Historical data has generally supported this view. SPIVA scorecards have shown over long periods of time that a majority of actively managed equity funds underperform their benchmarks. The case for indexing is not just philosophical — it is empirical.

Beneath this debate lies a deeper philosophical divide — one that is easy to overlook but essential to understand.

Passive investing is grounded in the Efficient Market Hypothesis (EMH), which holds that asset prices at any given moment reflect all available information. If that is true, then no investor — however skilled, however well-resourced — can consistently identify securities that are mispriced. Under the EMH framework, prices are generally viewd as fairly reflecting availabe informmation: not overvalued, not undervalued. They simply are what they are, given what the market collectively knows.

Active investing takes the opposite view. It is built on the belief that prices can be wrong — that some stocks are undervalued and others overvalued — and that a skilled analyst or manager can identify these mispricings before the rest of the market corrects them. Buy the undervalued. Sell the overvalued. Capture the spread as the market catches up.

These are not merely different strategies. They are fundamentally incompatible worldviews about how markets work. They reflect fundementally different views about how markets work.

The passive investor does not abandon the pursuit of return. Instead, returns are understood as compensation for bearing risk. Taking on more risk — owning more stocks, owning riskier asset classes, holding through volatility — has been associated with higher expected returns over time. Indexes, in this framework, are not just performance benchmarks. They are diversified buckets of risk, each one capturing a distinct slice of the global capital markets. Used together, they become the building blocks of a globally diversified portfolio — one that earns the market's returns because it is the market, or a carefully structured portion of it, held patiently over time.

Enter Dimensional Fund Advisors

By the early 1980s, a different kind of fund company emerged from the academic world. Dimensional Fund Advisors, co-founded by David Booth and Rex Sinquefield and shaped by the research of Eugene Fama and Kenneth French, took a position that was neither traditional active nor traditional passive. IFA thinks of Dimensional as non-traditional passive.

Their insight: markets are efficient, and there are systematic, persistent differences in expected returns across dimensions of the market, such as the Fama French five factors for stocks and two factors for bonds. Small-cap stocks have historically earned higher returns than large-cap stocks. Value stocks — those with low prices relative to fundamentals — have historically outperformed growth stocks. More profitable companies have outperformed less profitable ones. These are not anomalies to exploit through clever trading. They are risk premiums that the market has historically priced in, and harvested systematically at low cost based on the research indexes, such as those on Ken French's Data Library,  used to discover those factors. These factors simultaneously estimate the cost of capital for the shareholders of a firm (sellers) and the expected return for the providers of capital (buyers). (These historical relationships may not persist in the future.)

Morningstar classifies Dimensional funds as actively managed. So do most regulators. By traditional index fund definition, they're right — Dimensional funds are not tracking or seeking to replicate a published third-party index. But operationally, what Dimensional does looks far more like disciplined systematic investing than what most people picture when they hear "active management." Spend an hour watching Tune Out the Noise to really understand the history and underpinnings of Dimensional's unique approach to Dimensional index designs as well as their implementations in actual funds.

Dimensional has their own proprietary indexes — about 27 of them — that serve as the structural and systematic backbone of their funds. These Dimensional indexes are not licensed from a third-party provider like S&P or MSCI. They are built and maintained by Dimensional itself, grounded in the same academic research that defines their investment philosophy. Each index captures a specific dimension of expected returns — small cap, value, profitability, and others — with construction rules that reflect decades of factor research.

Every year, Dimensional publishes the Matrix Book, an annual compendium of long-term historical returns across all of their indexes and about 18 other indexes. IFA views it as one of the most data-rich documents in the investment advisory world, spanning asset classes, geographies, and time horizons. For advisors and investors trying to understand what drives returns over decades, it is an indispensable reference. More importantly, it is the evidentiary foundation that supports every structural and design decision in Dimensional's funds. These indexes are not marketing tools — they are the guiding light by which Dimensional's rules of construction are designed, tested, and refined. The table below compares their indexes to their funds.

The New Landscape: Three Forces Blurring the Line Further

Since the original version of this article in early 2025, three developments have made the active/passive distinction even harder to apply cleanly.

1. The Explosion of Active ETFs

The ETF wrapper — once almost synonymous with passive index investing — has become the vehicle of choice for a growing wave of actively managed strategies. In September 2025, the SEC notified Dimensional that it intended to approve its application for an exchange-traded fund structure, recognizing Dimensional's systematic approach as distinct from traditional active discretionary management.

Active ETFs now represent a substantial and growing share of ETF flows. The appeal is real: modern active ETFs can match the tax efficiency of index ETFs, trade intraday, and carry expense ratios far below those of traditional active mutual funds. The result is that "ETF" no longer signals passive investing — and increasingly, neither does "low cost."

2. Strategic Beta: The Middle Category That Didn't Fully Deliver

The 2010s saw an explosion of "strategic beta" or "smart beta" ETFs — index funds that tracked custom indexes built around factors like value, momentum, quality, and low volatility. The pitch was compelling: get the systematic factor exposure that explained much of active managers' outperformance, at index-fund costs.

The results were mixed. Many multifactor ETFs ended up concentrating heavily in one or two factors, often resembling value strategies more than true multifactor portfolios. They tracked an index — so Morningstar called them passive — but the index itself embedded active design choices about which factors to target and how.

As Morningstar noted in early 2026, these funds sit at "the intersection of active and passive": passive in their mechanical execution, active in the risk/reward trade-offs they embed. The lesson is not that factor investing failed, but that the index wrapper does not guarantee a sound or diversified implementation.

3. Direct Indexing: Owning the Portfolio, Not the Fund

Perhaps the biggest structural shift is the rise of direct indexing or separately managed accounts (SMAs) — a strategy in which an investor owns the individual securities that make up an index directly in a brokerage account, rather than shares of a fund.

Direct indexing has existed for years among ultra-high-net-worth investors, but declining trading costs and technology advances have pushed the minimum investment threshold down sharply. Firms like Parametric (now part of Morgan Stanley), Vanguard, Fidelity, Dimensional, and Schwab now offer direct indexing at minimums accessible to affluent retail investors.

Potential advantages may include:

• Tax-loss harvesting at the individual security level. When individual stocks decline, a manager can sell those positions to harvest losses — even if the index as a whole is up. In 2025 (based on publically available index data), a year when the S&P 500 rose nearly 18%, nearly 200 constituent stocks finished the year in negative territory. Index fund investors could not access those losses; direct index investors could.
• Investors can exclude specific companies or sectors — for ethical, religious, or risk-management reasons — without abandoning the broad market exposure.
• No fund-level capital gains distributions. Owning stocks directly means no forced recognition of gains from other investors' redemptions.

Is direct indexing "passive"? It tracks an index. But it involves ongoing trading decisions, is managed at the individual security level, and can be heavily customized. The answer depends entirely on how you define the term. IFA thinks of it as more of a tax strategy and as a consequence it would not be used in a tax deferred account.

A Better Framework: What Actually Matters

The active/passive label has become less useful for investors than it once was. What matters is not the label, but the underlying characteristics:

Systematic vs. Discretionary. Does the fund follow rules that are defined in advance, executed consistently, and applied without individual judgment calls about the pricing or prospects for specific securities? Systematic funds — whether they call themselves active or passive — remove the behavioral risks that sink most discretionary managers.

Costs. The arithmetic of compounding is relentless. Over 30 years, a 1% annual fee difference is not a minor headwind — it is a catastrophic one. Low cost is not sufficient on its own, but high cost almost always works against the investor.

Factor Exposure. What does the portfolio actually own, and what dimensions of expected return does it target? A market-cap-weighted S&P 500 fund gives you the broad market. A fund that tilts toward small cap, value, and profitability has historically been associated with higher expected returns in exchange for different risks and potentially longer required time horizons.

Turnover and Tax Efficiency. Frequent trading triggers taxable gains. Funds and strategies that minimize unnecessary turnover preserve more of the pre-tax return for the investor.

Benchmark Integrity. Index funds tracking well-known, market-cap-weighted benchmarks are extremely hard to game — because the index is public, transparent, and not designed to generate fees for an index provider. Custom indexes, by contrast, can be constructed to tell almost any story.

Where Dimensional Fits — and Where IFA Stands

At IFA, we recommend a wide range of passive fund managers, such as Advantis, Vanguard, Blackrock, Schwab and Fidelity, but our default portfolios are from Dimensional Fund Advisors because we believe their approach represents the a compelling synthesis of academic evidence and investment principles we value.

Dimensional funds are:

• Systematic and rules-based — no stock picking, no market timing
• Grounded in academic research — the Fama-French Five-Factor Model underpins every portfolio
• Low-cost relative to active peers — but not the cheapest option for someone content with market-cap indexing
• Factor-tilted — designed to
  target size, value, profitability, and investment factors that have historically been observed in market data
• Patient traders — Dimensional's patient trading approach allows them to act as a liquidity provider rather than a liquidity demander, reducing transaction costs

We do not believe that owning the broadest possible market-cap-weighted index is the only defensible approach. We believe the evidence supports systematic factor exposure when implemented patiently, at low cost, with full diversification. IFA believes that Dimensional's approach is designed to deliver those characteristics.

But we also respect investors who choose low-cost broad market index funds from Vanguard, Fidelity, or Schwab. A total market index fund held for decades, at minimal cost, with disciplined rebalancing has historically outperformed a majority of actively managed alternatives over long periods. The enemy is not market-cap indexing — it is high-cost, discretionary, performance-chasing active management.

The Bottom Line

The question "What really is an index fund?" does not have a clean answer anymore. The investment industry has evolved in ways that make the traditional binary misleading. Active ETFs can be systematic and low-cost. Index funds can embed unique design choices through unpublished custom benchmarks. Direct indexing is neither a fund nor purely passive. And some of the most evidence-based investment firms in the world are technically classified as active managers.

What has not changed is the underlying logic: markets are largely efficient, prices are right, costs compound relentlessly against investors, and disciplined systematic exposure to the dimensions of expected returns has historically been associated with more favorable long-term outcomes than many forms of stock selection, market timing, manager selection, or tactical asset allocation.

The label matters less than the substance. Ask not whether a fund is called active or passive. Ask whether it is systematic, low-cost, broadly diversified, grounded in evidence, and appropriate for your time horizon and risk capacity.

That question will serve you better than any label ever could.