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 (ETFs) that follow a set of rules of ownership, which under normal circumstances, are held constant. (For more information, see Mark Hebner's video above "What are Index Funds?")

Thousands of different index mutual funds and passively managed exchange-traded funds are being sold in the U.S. At the same time, it's not uncommon for hundreds of new index funds — typically packaged these days as ETFs — to launch on U.S. exchanges in a year. "There's no question asset managers are working hard to find new opportunities in an extremely saturated marketplace," said Elisabeth Kashner, head of global funds research and analytics at FactSet Research. 

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 "ESG" (Environmental, Social and Governance) investment strategies. A broader blurring of the lines is also taking place, noted Kashner, as active managers try to increase their presence in "thematic" ETF fields dominated in the past by indexing rivals. 

This is leading ETF manufacturers to come out with novel product names and marketing campaigns to separate themselves from the pack. "But it's not as if there's anything really new about any of these investment strategies," said Kashner.

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

Ben Felix, a Canadian-based portfolio manager at PWL Capital, is even more blunt. "Unfortunately, the financial industry does not like making things easy for investors," he said. "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."

Different Definitions of Index Funds

The Securities and Exchange Commission has described an index fund as a type of mutual fund or ETF that tracks the returns of a market index such as the S&P 500 or the Russell 2000. In an investor bulletin first issued in 2018, however, SEC officials pointed out that nowadays some of these funds "use more complex or targeted investment strategies than have traditionally been associated with index funds." 

As a result, they've sought to alert investors to a broader definition that includes "non-traditional" index funds. Unlike traditional variations, according to the SEC, non-traditional funds "use custom-built indexes to select the fund's investments." Taking advantage of a specially designed benchmark, the regulator noted, means that "a non-traditional index fund may seek to achieve performance greater than a particular market or sector." 

The SEC's bulletin characterizes non-traditional index funds as being "constructed using criteria that a manager might consider when actively managing investments in a fund." The investor bulletin, which has been updated since its initial release, added:

"But non-traditional index funds are still 'passively managed.' The investment adviser seeks to track an index, rather than using its own independent judgment to manage the fund's investments."

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

At Morningstar Inc., researchers describe an index fund in much the same manner. "If we go back to the early days of indexing, funds were simply tracking market-cap weighted commercial indexes like the S&P 500," said Daniel Sotiroff, a senior Morningstar analyst in Chicago. "But over the years, the market has evolved to include a broader spectrum of funds and indexes."

For investors, such an expansion of indexing strategies has translated into "a blurring of the lines between definitions of passive and active funds," he observed. "As indexing has grown to incorporate a broader range of themes and investment strategies," Sotiroff added, "the line just isn't as black-and-white anymore."

An example of a popular strategy is factor-based investing, which aims to exploit known drivers of longer-term returns such as size, value and profitability. Other emerging sleeves, Sotiroff observed, include funds focused on themes relating to environmental sustainability and socially responsible investing. "These can act much differently over time than older plain vanilla, broad-based total stock market types of index funds," he said.

How are DFA Funds Different? 

A pioneer in factor-based fund strategies, 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 Sotiroff.

Instead, they're allowed to consider daily pricing in buying and selling stocks and bonds with similar characteristics. "On the trading and execution side of things," Sotiroff said, "they're basically doing modest rebalances day in and day out."

By contrast, he pointed out that DFA applies a rules-based and passive approach to developing and managing a fund's investment strategy. "When you look at the overall process, we consider their funds as acting very index-like," Sotiroff said. "DFA is taking a passive approach in the fund construction and management processes, but on the trading and execution side they're allowing for a little more flexibility than a traditional index fund."

It's worth noting that Dimensional Founder and Chairman David Booth supported such a view in his 2001 paper "Index and Enhanced Index Funds." He wrote:

"(Dimensional's) funds under management are either 'index funds,' designed to closely track the returns of an index, or 'enhanced index funds' ... The goal of our enhanced index funds is to add 100-200 basis points a year over conventional benchmarks while tracking their benchmarks almost as well as index funds." 

Likewise, DFA'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.

A comparison of an IFA Index Portfolio taking what might be considered as a more "moderate" or "balanced" approach — say, 60% allocated to equity funds and 40% to fixed-income funds — provides us with another view of how closely Dimensional's investment process coincides with an "index-like" outcome for our clients.

The chart below shows funds used in an all-DFA implementation of the IFA Index Portfolio 60. It also lists each fund's respective benchmark. The period used is the longest available in which all of these funds have been in existence. Not only are the risk characteristics (as measured by standard deviation) notably similar, but so are the annualized returns. 

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 said. "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."

Technological Innovations in Indexing

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 said, "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 added. 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, which is owned by the London Stock Exchange, put 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 are brought 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 pointed 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/