Index Block

A Blurring of the Lines: What Really is an Index Fund?

Index Block

As index investing moves into the American mainstream, industry researchers point to a "blurring of the lines" between what can be considered as active and passive management.

IFA defines index funds as mutual or exchange-traded funds that follow a set of rules of ownership which are held constant regardless of market conditions. (For more information, see Mark Hebner's video below "What are Index Funds?")

Entering 2021, more than 2,900 different index mutual funds and passively managed exchange-traded funds were being sold in the U.S., according to Morningstar. These accounted for slightly more than $9.3 trillion in combined assets.   

Despite a pandemic, 2020 set a new record with more than 300 launches of ETFs on U.S. exchanges, according to FactSet Research, another independent funds data provider. "There's no question asset managers are working hard to find new opportunities in an extremely saturated marketplace," says Elisabeth Kashner, head of ETF research at FactSet.

Some funds are pitching themselves as "smart beta." Others are going by the moniker of "systematic" and "quantitative." There are also managers who are labeling themselves as "enhanced" indexers or purveyors of "low volatility" investment strategies. 

As a result, manufacturers are coming out with novel product names and marketing campaigns to separate themselves from the pack, Kashner says. "But it's not as if there's anything really new about any of these investment strategies," she adds. 

The concern is such jostling by fund providers "might be disconnected from what investors want or really need," Kashner says. It also creates a sense that some investors are feeling a bit "overwhelmed" with all of these seemingly new fund iterations, she adds.

Ben Felix, a Canadian-based portfolio manager at PWL Capital, is even more blunt. (See video below.) "Unfortunately, the financial industry does not like making things easy for investors," he warns. "With the increasing popularity of index funds, index creation has become big business. There are sector index funds, smart beta index funds, equal-weighted index funds, and many others — making it that much more challenging for investors to make sensible investment decisions."

FactSet, which is headquartered in Norwalk, Conn., traditionally has defined index funds as those that are fully rules-based as opposed to "those with investment processes that rely on human judgment," Kashner says. 

At Morningstar, researchers describe an index fund in much the same manner. "The way in which index funds are developed and presented to investors keeps evolving," says Ben Johnson, head of global ETF research at the Chicago-based independent investment data provider. "For example, factor-based stock investment strategies try to exploit known drivers of longer-term returns such as size, value and profitability. These can act much differently over time than older plain vanilla, market-cap weighted index funds."

The pioneer in this field, Dimensional Fund Advisors (DFA), is categorized by Morningstar as dipping into active management. That's primarily due to the fact that fund managers aren't required to adhere to a computer-generated list when trading securities, according to Johnson.

Instead, they're allowed to consider daily pricing in buying and selling stocks and bonds with similar characteristics. "But it's important to understand these trades are done on a fairly limited and structured basis," Johnson says. "DFA is still absolutely a rules-based and index-like strategy."

In his view, Dimensional's funds retain the best qualities of indexing while providing a little more "wiggle room" in its methodology than traditional index managers. "This is a perfect example of a blurring of the lines," Johnson says. "For all intents and purposes, DFA's approach is pretty much a paint-by-the-numbers methodology." 

Likewise, Dimensional's funds are designed to offer investors exposure to key markets in a straightforward and transparent manner. Its U.S. Small Cap Value (DFSVX) fund, for example, targets the smallest 10% of domestic stocks by market cap. The selection process includes securities down to $10 million in market capitalization size, which provides coverage of micro caps. Within this part of the market, the fund's guidelines focus on the lowest 35% of stocks as screened by price-to-book ratios. Those with low profitability and high asset growth are excluded.

At the same time, Dimensional's U.S. Large Cap Value (DFLVX) follows eligibility and weighting guidelines that target the largest 90% of domestic stocks by market cap size. Within this part of the market, the fund focuses on the lowest 30% of stocks by price-to-book, resulting in a built-in emphasis on mid caps. Its guidelines are tilted to favor stocks with lower relative prices and higher levels of profitability.

Like its small value cousin, the large value fund screens out REITs and underweights highly regulated utilities. Both also set a maximum 10% sector overweight relative to each fund's style-neutral, size-eligible universe.

John Rekenthaler, another veteran Morningstar researcher, finds that some institutional investors like to use "selective indexing" when referring to quantitative or enhanced index fund strategies.

Under such a definition, these funds follow execution rules aimed at lowering trading expenses and avoiding unprofitable companies. "This is essentially how Dimensional runs their funds," Rekenthaler says. "It was once considered as an index provider, but now DFA is being viewed in the marketplace as somewhat of an active manager. That's largely because of the changes that it makes when converting its theoretical screening of securities into investable funds."

Another major driver of updated definitions for index funds relates to advances in computer applications used to calculate and disseminate market data, observes Catherine Yoshimoto, director of equity index products at index provider FTSE Russell. "We've seen an evolution in technology that's not only bringing about a lot of new products," she says, "but it's also allowing us to incorporate different algorithms into indexes. That's enabling us to refine our methodologies to be more closely aligned with an investor's specific goals."

Advances in quantitative research and other sophisticated computer modeling techniques mean "we can quantify and refine our index methodologies in a more exacting form," Yoshimoto adds. As a result, she suggests investors focus on an index's "pre-defined set of rules" and established processes to gain exposure to a specific market or investment goal. 

Along these lines, how an index fund captures an asset class and weights its constituents -- rather than how closely it sticks to a list of names -- are defining characteristics for IFA's investment committee. As FTSE Russell puts it:

"An index is a basket of securities selected on specific criteria and aims to track a particular investment theme, such as a market, a region, an asset class, sector, industry or strategy. Generally, the goal is to accurately represent the risk/return goal of that theme."

Still, in such a competitive and evolving marketplace, trying to find a consensus on what's really an index fund (and what isn't) courts walking a rather slippery slope. Even so, from our continued discussions with major industry players and researchers, one area of common ground clearly emerges — namely, agreement on what constitutes active management. That is: a manager who tries to time the market or find mispricing in securities across different markets and asset classes. 

Leading industry researchers note a key takeaway for investors is that no matter what innovations come-to-market in coming years, the fundamental benefits of following a rules-based and systematic approach aren't likely to change. As Morningstar's Rekenthaler points out:

"The historical results aren't very good for index fund managers who've tried to enhance returns by adding active individual security selection into the selection process. They've rarely excelled, and in fact, they've failed on the whole to produce strong track records over time. But there's a lot to be said for adopting a selective indexing approach and permitting a fund's portfolio more flexibility to reduce execution costs. The simple practice of avoidance of some securities gives management the opportunity to pick up some nickels along the way."

Given such innovative advances in fund management, IFA's investment committee continues to monitor and assess new fund methodologies and products. We're loathe, however, to jump on the active management bandwagon and lump all of these so-called quantitative processes in the same manner. 

We do find that select enhancements to traditional indexing readily support and improve our passive management strategy in designing globally diversified portfolios of mutual funds and ETFs. In particular, IFA finds that Dimensional's academic rigor and systematic investment process continues to provide our clients consistent and efficient access to key markets and asset classes. Our research shows that DFA's highly structured trading methodology is executed in a fashion that reduces both implicit as well as explicit management and operational costs to fund investors. 

Although we realize some fund ratings companies might consider these types of quant funds as too 'cutting edge' to be part of the index fund category, IFA's ongoing market analysis gives us confidence that Dimensional's eligibility and weightings guidelines used to manage its funds continue to hold true to modern indexing's most fundamental and important characteristics. 


This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. IFA Index Portfolios are recommended based on time horizon and risk tolerance. Take the IFA Risk Capacity Survey (www.ifa.com/survey) to determine which portfolio captures the right mix of stock and bond funds best suited to you. For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/