Passive in Name Only? Why ‘Passive’ Funds Might Not Be So Passive After All

It’s no secret that index investing has taken the investment world by storm. Trillions of pounds and dollars have flowed into funds that track broad market benchmarks, driven by the promise of low fees, broad diversification and hands-off exposure to market returns. But what if many of these so-called ‘passive’ funds weren’t truly passive at all?

That’s the question posed by Ayres, Green and Wang in their fascinating paper Passive in Name Only: Delegated Management and ‘Index’ Investing (2018). Their central claim is simple but powerful: while index funds may market themselves as passive, in practice, there’s a surprising amount of active decision-making going on behind the scenes.

Passive? Or Just Pretending?

One of the most striking points Ayres et al. (2018) make is that anyone can make up an index. There is no universal definition of what constitutes an index — they are constructed by humans, using a set of rules (often subjective) about what to include, how to weight it, and when to rebalance. You could create an index of ‘UK mid-cap stocks with a bird in the company logo’ and start a fund to track it. Would that be a passive strategy?

Technically, yes — you’re tracking a predefined set of rules — but in spirit, absolutely not. You’ve actively chosen the universe, the criteria, and the rebalancing rules. That is active management masquerading as passive. And yet, many funds operate like this: selecting niche or custom indices with opaque methodologies, slapping on the ‘passive’ label, and presenting themselves as low-cost, rules-based alternatives to active management.

This is what the authors mean by ‘passive in name only’. True passivity requires delegating decision-making to the market itself — owning everything in proportion to its market capitalisation, without injecting personal judgement. But once a fund manager starts making decisions about what to include or exclude, even via a third-party index, the process becomes a form of active delegation.

This matters because the illusion of passivity can lead investors to overlook fees, benchmark mismatches and unnecessary complexity. If a fund is tracking an obscure index few people understand, and charging 0.5% for the privilege, is that really a passive investment? Or is it simply active management hiding behind an index-shaped curtain?

Dimensional and Avantis: Redefining Passive?

The blurred line between passive and active investing is perhaps best illustrated by firms like Dimensional Fund Advisors (DFA) and Avantis Investors. These managers don’t track traditional indices at all — yet they are often associated with the passive investing movement.

Dimensional constructs its own rules-based portfolios grounded in academic research, especially the work of Fama and French on size, value and profitability factors. While Dimensional does not consider itself an active manager in the conventional sense — it does not rely on forecasts or individual stock selection — it makes discretionary decisions around portfolio construction, including how and when to trade, how to tilt towards certain factors, and how to exclude certain securities (Dimensional 2023).

Avantis, a newer player led by former Dimensional executives, operates on a similar basis. Its portfolios are systematically designed to capture market premiums — such as value, profitability and momentum — but with an added layer of flexibility. Managers have discretion to deviate from strict rules if doing so is expected to improve implementation or reduce trading costs (Avantis 2023).

Both firms fall into what Morningstar and others have called ‘rules-based active’ or ‘enhanced indexing’. They use transparent, evidence-based rules, but the execution of those rules — and the freedom to deviate when beneficial — places them somewhere between traditional passive and active management.

Crucially, they don’t try to beat the market through stock picking or timing — but neither do they outsource every decision to an external index provider. This makes them deliberately and transparently active, despite sharing many of the cost and diversification benefits of passive investing.

Return Dispersion Among ‘Passive’ Funds

Ayres et al. (2018) also uncover wide variation in returns among funds that claim to track the same index. For example, S&P 500 index funds have shown performance spreads of up to 0.6% per year, due to differences in fees, trading strategy and replication methods (Johnson 2021). Among Russell 2000 funds, the spread can be even wider — as much as 1.0% annually — due to illiquidity and the complexity of implementing rebalances (Israeli, Lee, and Sridharan 2017).

Over a 40-year horizon, a £100,000 investment growing at 7% annually becomes around £1.5 million. At 6.4% (i.e. 0.6% less), it grows to £1.2 million. At 6.0%, it becomes £1.0 million. In other words, a seemingly small difference in annual return can cost an investor £300,000 to £500,000 in final wealth.

What’s more, these performance gaps persist. Funds that lag their benchmark in one period are often the same ones that underperform in the next. For investors who assume passive funds are indistinguishable, this persistence should raise eyebrows.

Fee Dispersion and Investor Blind Spots

The paper also reveals a surprisingly wide range of fees among passive funds. While ultra-low-cost trackers from the largest providers are well known, many index funds charge substantially higher fees despite tracking similar or even identical benchmarks. The variation is often hidden behind the passive label, which can lull investors into a false sense of security.

Ayres et al. (2018) find that high-fee index funds often attract and retain assets despite underperforming their cheaper peers. This suggests that some investors may be paying more for less, possibly unaware of the extent to which their ‘passive’ fund deviates from the underlying index or how much discretion the manager really has.

Passive Isn’t Always Passive

All of this leads to a clear conclusion: the line between active and passive management is blurrier than many realise. The term ‘passive’ has become a marketing shorthand, often masking subtle forms of active decision-making embedded in index design and implementation.

Whether it’s traditional index funds making strategic choices about tracking, or innovative firms like Dimensional and Avantis building systematic portfolios from scratch, the reality is the same: label alone is not enough to determine how a fund actually behaves.

For investors, this means it’s essential to look beyond the label. Understand which index a fund tracks — or how it constructs its portfolio — how closely it tracks it, how much it charges, and how it has performed relative to its stated benchmark. The differences may be greater than you think — and they could cost you.

Final Thoughts

As the passive investing revolution continues, it’s worth remembering that not all passive funds are created equal. Ayres, Green and Wang offer an important reminder: just because a fund claims to be passive doesn’t mean there’s no active judgement involved. And as managers like Dimensional and Avantis demonstrate, rules-based investing often lives in the grey zone between active and passive. In a world where the passive label is often used as shorthand for simplicity and low cost, that’s a distinction worth keeping in mind.

References

Avantis Investors. 2023. Investment Philosophy and Approach. https://www.avantisinvestors.com.

Ayres, Adrian, Richard C. Green, and Yanbo Wang. 2018. Passive in Name Only: Delegated Management and ‘Index’ Investing. Working paper. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3100692.

Dimensional Fund Advisors. 2023. Investment Principles. https://www.dimensional.com.

Israeli, Doron, Charles M.C. Lee, and Suhas A. Sridharan. 2017. ‘Is There a Dark Side to Passive Investing? Regulatory and Efficiency Implications of Passive Ownership’. Journal of Financial Economics 132 (2): 263–282. https://doi.org/10.1016/j.jfineco.2017.06.004.

Johnson, Ben. 2021. Do Investors Still Love the S&P 500? Morningstar. https://www.morningstar.com/articles/1025062/do-investors-still-love-the-sp-500.