Not all index investing is passive investing

I used to think passive investing to be synonymous with index investing. Over time, my understanding has changed thanks to articles such as Data Mining in Index Construction: Why Investors need to be cautious.

Factor indices such as “quality” and “value” are not quite passive because the index construction methodology is not much different from what an active fund manager may do. There are factor indices constructed using less subjective factors too, such as equal weight. Since an equal weight index fund will have to constantly buy and sell to keep the constituents at roughly equal weights, the fund is hardly passive.

Okay, factor index funds are not passive. But what about funds like Nifty Next 50? They are market-cap weighted, so there’s no frequent buying and selling. Constituents are also determined by the market rather than arbitrary criteria on “quality”, “growth”, etc. Would that qualify Nifty Next 50 funds as passive? I am no expert, but I think they are still somewhat active because an index like Nifty Next 50 does not track the market. Such an index gives you return and risk that’s not necessarily correlated with the entire market. You are basically tracking an arbitrary subset of the market instead of tracking the entire market.

Index investing in India usually means investing in the Nifty 50 index. Even firm believers of index investing often recommend against investing in a more holistic index due to liquidity issues and elevated impact cost. Nifty 50 is an approximation of the Indian equity market rather than the whole Indian market. Therefore, one can argue that Nifty 50 is also an active choice: you choose to leave out the bottom of the market because you think those companies don’t add much value. A “true” index investor wouldn’t do that.

If you are wondering why I care so much about investing in the whole market, you’ll find the arithmetic of index investing interesting. But don’t get me wrong: I am not arguing that everyone should invest in the entire market. I am only observing that pure index investing may not be practical for most investors. Being pedantic and dogmatic is seldom good; investing is no different.

Active vs Passive

Passive investing is where you minimise activity. Activity includes decision making. The more decisions you make, the more active your investing style is. Choosing to buy and sell frequently? That’s active investing because there’s a lot of trading activity. Investing in a subset of the equity market? That’s active too, because you are actively leaving out a part of the equity market.

Here is my attempt to sort various mutual funds and ETFs on how active or passive they are.

1. On the one extreme, we have active mutual funds, such as Axis Bluechip, Parag Parikh Flexicap, etc. It should be no surprise that I consider these funds the most active.
2. I’d put sectoral funds, such as Tata Digital India after this. While these funds may track every company in an industry similar to an index fund, these funds are for taking concentrated active bets. The investor is actively choosing a sector to invest in.
3. Factor index funds such as Low Volatility Index, Equal Weighted Index, etc. Some of these indices do active stock picking (albeit with a set of predefined rules) while others do frequent buying and selling. Both qualify as active.
4. Index funds that track some “middle of the market”, such as Nifty Next 50, Nifty Midcap 150, etc. Because they are in the middle, the risk and return of these indices likely won’t have much correlation with the whole market.
5. Index funds that track the “top of the market”, such as Nifty 50, S&P 500, etc. While these funds still pick one part of the market and leave out the rest, they often correlate with the risk and return of the whole market.
6. Index funds that track the entire market of a country or a region, such as VTI (which tracks the whole US equity market) or funds that track the MSCI World index.
7. Index funds that include every company in the world, such as VT, are on the other extreme. These are the least active because they represent the entire universe of investible companies and they don’t do frequent buying and selling.

This list isn’t exhaustive. There are options like VWRA that don’t fit in any of the aforementioned categories. VWRA is similar to VT but with limited small cap exposure, so it’s a blend of #7 and #5.

I used to think that all index investing is passive. After looking at all the practical options an investor has, I am convinced that pure index investing is seldom practical. Most index investors would end up choosing an active index, but that’s not necessarily a bad thing.

I also used to think active and passive investing as 2 absolute opposites. But now I know that active and passive are 2 edges of a continuum, and your investment is almost always a blend of active and passive strategies. You fall somewhere in the middle of the spectrum.