Index Funds May Be More Active Than You Think

Index funds are widely viewed as a way for investors to achieve broad, passive exposure to certain markets or asset classes. However, investors may overlook the fact that the creation and maintenance of an index fund entails numerous active decisions. Indeed, index providers make many choices that have important implications for the characteristics and returns of the benchmarks they produce.

This can be seen in how indices designed to target the same asset class can often have disparate returns.

In a recent paper titled “Indices Acting Active,”¹ Dimensional looked at the annual returns of three US small cap indices over the past 20 years ending in 2023 (see Exhibit 1). The average return difference between the best and worst performer was 4.9%, and in some years that difference was markedly higher. For example, in 2009 and 2021, the return of the best-performing index exceeded that of the worst-performing index by more than 10%.

Exhibit 
Which US Small Cap Index Is Passive? 
Annual returns (%), 2004–2023

Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

Return variations of this magnitude may be more commonly associated with active strategies than with indices passively tracking the same asset class.

This observation is not unique to small cap indices. Perhaps surprisingly, even indices designed to represent the total US market can behave differently from one another. We found that the annual difference in returns between the best and worst performer among four providers of total US market benchmarks over the past 20 years ranged from 0.2% to 3.2%, with an average of 1% per annum.²

These return differences underscore the reality that no single approach exists to defining a market. According to the Investment Company Institute, “index construction and administration often involve a significant number of assumptions, inputs, rules, and methodological choices.”³ Among these are which stocks and countries to include, what weights to give them, and when to add them.

Hidden Costs of Index Funds

Common practice has been to measure index fund managers by how closely they track their target indices. However, tracking error does not reveal the impact of methodology decisions made by index providers. If the index experiences style drift and the manager tracks the index perfectly, the opportunity cost is hidden within a low-tracking-error metric.

For example, an index fund may buy an addition to the index at the same price it enters. However, if the index provider has taken several months to include an eligible stock because it was waiting for its reconstitution date, then returns may have been missed in the meantime. Equally, if one index is slower to include a stock than its peers because it has stricter eligibility rules, then that will have a knock-on effect on the funds tracking it.

Index fund managers who focus on tracking their target benchmarks are essentially outsourcing decisions regarding the construction and maintenance of their portfolios to index providers. However, index providers themselves typically are not fiduciaries. Major index providers are usually independent third parties.

According to MSCI: “This fiduciary duty is fundamentally at odds with the role of the index providers in the capital markets ecosystem, which is to produce independent and rules-based information for use by market participants.”⁴ S&P Dow Jones echoes that sentiment: “Each index is designed in accordance with stated rules; it is not intended to meet the investment objective of any individual licensee or investor.”⁵

Overall, there isn’t one best approach to delivering market exposure, so, beyond tracking considerations, it is important for index investors to perform due diligence on decisions made by their index provider. As with any investment strategy, it is imperative for investors to evaluate whether these choices align with and serve their investment objectives.

Footnotes

^1. Karen Umland, “Indices Acting Active: Index Decisions May Be More Active than You Think” (research paper, Dimensional Fund Advisors, February 2024).

^2. Indices observed include S&P Composite 1500 Index, MSCI USA IMI Index (gross dividends), Russell 3000 Index, and CRSP US Total Market Index from 2004-2023.

^3. “Indexes and How Funds and Advisers Use Them: A Primer,” Investment Company Institute, January 2021.

^4. Neil Acres, Managing Director and Global Head of Government and Regulatory Affairs, MSCI Inc., letter to US Securities and Exchange Commission, August 15, 2022.

^5. Joe DePaolo, General Counsel, S&P Dow Jones Indices, letter to US Securities and Exchange Commission, August 16, 2022.