When I started investing eight years ago, I thought all ETFs were index funds and that all index funds were passive.
I was wrong, a victim of oversimplification – black-and-white thinking.
There are over 8,000 Exchange Traded Funds (ETFs) worldwide, according to Blackrock.
Choosing among 8,000 alternatives can be confusing, especially given that:
- Not all ETFs are index funds.
- Not all index ETFs are passive.
- Not all index funds are diversified.
This post aims to help you differentiate between index funds by measuring diversification and fund activity.
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Not all ETFs are Index Funds
First, there are actively managed ETFs. These are actively managed funds that happen to trade on an exchange – an “Exchange Traded” Fund (ETF).
As an example, I’ll use the ARK Innovation ETF, which trades on the NYSE Arca exchange under the ticker ARKK.
An investor who buys the ARKK ETF pools their money with other investors.
The fund manager (Cathy Wood) uses the pooled funds to invest in stocks. Specific stocks are bought and sold based on Cathy’s judgement.
As per the fund description, at least 65% of the fund’s assets are invested in disruptive innovation companies.
There are many actively managed funds that trade as ETFs. Not all ETFs are index funds.
What is an Index ETF?
An index fund tracks the performance of a particular index, such as the S&P 500.
But how would a fund track performance?
An index fund holds all stocks that make up the index in the same proportion that the stocks are represented in the index.
Fund Turnover: A Measure of Active vs Passive
To determine the level of fund activity, you can ask, “how much buying and selling is going on in the fund?”
Fund turnover measures the percentage of the fund’s assets bought or sold in one year. The higher the turnover rate, the more active the fund.
You can find the turnover rates in an index fund fact sheet or through your brokerage.
For example, here is data that I pulled from RBC Direct Investing for various index funds at the time of writing (April 2023).
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Index Rules (Methodology): A Passive vs. Active Delineator
An index is a basket of stocks. But what determines the degree of turnover of stocks in this basket?
Each index is managed by an organization. This organization sets rules that determine what stocks can be included in the index.
Rules for stock inclusion are called the “index methodology.” The index methodology determines:
- The level of index diversification
- The degree of index “activity”
For example, S&P Dow Jones Indices defines many stock (equity) indices, including:
- The S&P 500
- The S&P/TSX Composite Index (Canada’s main index)
- The S&P/TSX 60 index.
S&P Dow Jones Indices defines the index methodology for each index.
Let’s look at the index methodology for the S&P/TSX 60 index. This index holds the 60 largest stocks in Canada.
The rules for the S&P/TSX 60 index are not 100% black and white. What happens if one of the largest 60 companies throws off the sector balance?
Employees (humans) at S&P Global must apply judgement to determine what stocks are included in the index. Such application of judgment is a form of “active” management.
Even if the rules were 100% cut and dry, stocks grow and shrink over time. Some stocks may no longer be in the top 60.
When stocks no longer meet index criteria, they are sold by the index fund. The index fund must then purchase a replacement stock.
The index rules determine how much buying and selling goes on in the fund. The level of buying and selling determines the turnover rate – how “active” the fund is.
I no longer look at active vs passive as black and white. Instead, view it as a spectrum.
Portfolio Manager vs A Set of Index Rules
What’s the difference between an analytical portfolio manager and an index with a good set of rules for stock inclusion? This is a fascinating question. I argue that the two begin to converge.
If I had to select an active portfolio manager, I would choose someone with a robust set of analytical rules for stock selection.
Rules negate emotional decisions that result in buying high and selling low.
As an engineer and manager, I know good decisions result from a robust process. And a good process is a set of rules.
Speaking of rules … the stocks on an index are selected based on rules.
Could you not just take the rules used by the active (analytical) stock selector and use those rules to design an index?!
I argue that a rules-based stock selector could have their rules for stock selection condensed into a rules-based index. The index could then be tracked by an index fund.
Sure, a professional fund manager has other traits that can’t be baked into a set of rules. Perhaps they have more refined judgment relative to an automated set of rules.
But the fund manager is human. They are prone to human biases. Furthermore, the fund manager would incur more fees relative to an automated rules-based indexing approach.
Due to fees and the return-chasing tendencies of fund managers, I would pick the rules-based indexing approach.
An example of an active fund that uses a rules-based indexing approach is the Avantis Small Cap Value ETF AVUV. The approach keeps expense ratios low, at only 0.25%.
The Most Passive Form of Index Investing
The most passive indices are total market indices, like the CSRP US Total Market Index. The index methodology is simple – include all stocks in the US market.
Overall, minimal trading goes on in the fund. Stocks grow and contract organically within the fund.
Since billionaire wealth is mainly tied up in stocks, the video is a good proxy for the organic change in stock value.
More Passive, More Tax Efficient
By minimizing buying and selling, the total market index fund is tax-efficient. This is one of many reasons why I love total market index funds.
When a stock is sold, it triggers a taxable event called a capital gain.
Passive total market index funds minimize buying and selling of underlying stocks. In turn, they reduce realized capital gains taxes and improve tax efficiency.
An Index With Active Flavour: Vanguard SCV ETF
In contrast to a total market index, consider Vanguard’s Small Cap Value ETF (VBR). It holds all stocks on the CRSP US Small Cap Value Index.
First, you may ask “what are the rules to include stocks in the CRSP Small Cap Value (SCV) index?”
CRSP defines the rules for stock inclusion on the SCV Index:
- book to price
- forward earnings to price
- historic earnings to price
- dividend-to-price ratio
- sales-to-price ratio
Note that the rules for stock inclusion are far more complex relative to the rules for VTI. Therefore, VBR will buy and sell stocks more frequently than VTI. The index fund VBR is more active than the index fund VTI.
For example, what happens when a stock shoots up in valuation and no longer has a low price-to-earnings ratio?
It will no longer be a value stock, therefore, VBR must sell the stock.
Hence why the turnover rate for VBR is 3x higher than the total market fund VTI. The turnover of VBR is 13.1%, and VTI turnover is only 4%.
As the complexity of rules for inclusion increases, the fund becomes more “active”.
Why Not all Index Funds are Diverse
Consider a total market index, like the CSRP U.S. total market index. The 4000 + stocks are spread across the 11 sectors.
The total market index is well diversified across sectors.
Now change gears and consider the index fund IDRV which tracks the NYSE FactSet Global Autonomous Driving and Electric Vehicle Index.
The index rules include stocks that are involved with EVs and autonomous driving. The rules result in a basket of stocks with near-zero exposure to 7 of the 11 sectors.
IDRV is an index fund, but it is not diversified.
Due to sector concentration, investing in IDRV increases risk above VTI. In addition, the increased risk does not come with increased expected returns.
To deepen your understanding, see why diversification reduces returns without reducing risk.
How to Tell if an Index Fund is Passive or Diverse
To measure fund activity, you can use the turnover ratio. “How do I find the turnover ratio”?
The turnover ratio for an index fund can be found through your brokerage or on the fund fact sheet. It can be useful to look at turnover from multiple years, to get a good idea of future expectations.
An index with complex rules for inclusion will normally have a higher turnover ratio.
To measure diversification, most brokerages will provide the following information
- The number of stocks in the fund
- The fund’s sector balance
- The fund’s geographic breakdown
For example, RBC Direct Investing shows me the sector breakdown for the index fund VCN which tracks the S&P/TSX Composite Index.
A set of rules defines what stocks can be included in the index. Complicated rules can produce a high turnover of stocks in the index. Therefore, some index funds are more “active” than others.
In addition, not all index funds are diversified. Examples include an EV Index, a Solar Power Index, or the NASDAQ 100 Index (with index fund QQQ).
I think it’s fun to ask, “what’s the difference between a human selecting stocks based on rules and an index that selects stocks based on rules?” An excellent human decision-maker selects stocks based on a set of rules. An index is also a set of rules.
Finally, the most passive index is a total market index fund. Not only does a total market fund tax-efficient, but it also provides the highest expected returns for a given amount of risk.