Passive Index Investing is an investment approach characterized by four main features: 1) the index, 2) the index fund, 3) passive management as opposed to active management, and 4) low costs.

1: The index

If passive index investing were the solar system, the index would be the sun. Because everything orbits around the index.

If you’ve been exposed to terms such as the S&P 500 and Dow Jones, then you’ve been exposed to indices, for each of these are stock market indices oft-cited in the context of gauging how portions of the U.S. Stock Market are performing.

Suppose the entire world economy is “Market.” Which means you can think of Market as a pie filled with every ounce of economic activity—all markets, all industries, all companies, all trade.

And if you were staring down at Market, you’d be understood if you thought you were looking at a freshman college student waking up to a hangover. Disorganized. Disheveled. In disarray.

And so, in the way humans do, we reduce and isolate and draw lines and put things into categories because (sometimes) this helps us make sense of what appears to be an incoherent whole. Which is how we arrive at indices: economists and financial professionals take a snapshot of Market (remember, it’s a pie) and chop it up into more manageable slices referred to as indices.

For example if the CRSP U.S. Total Market Index (an index that constitutes the entire U.S. Stock Market) is a slice of Market, then the S&P 500 is a slice of what the CRSP index represents. And then the Dow Jones is a slice of what the S&P 500 represents.

The number of slices is a long, varied list. There are international stock market slices, emerging market slices, bond market slices, industry-specific slices, slices based on companies with “strong Environmental, Social and Governance (ESG) practices,” and on. The number of ways to slice or “index” pieces of Market is infinite as you can carve Market however you please and serve it up as an index.

In isolation an index is nothing more than a bunch of arbitrary data points you may or may not glean useful information from. It is a mathematical construct. And important to highlight, not a security. You don’t trade it or invest in it. An index is simply a measure of or reference to the state of some segment of the world.

Indices have a variety of uses in practice. One of which includes being the centerpiece of the index fund.

2: The index fund

An index fund is an investment vehicle—a mutual fund or exchange trade fund (ETF)—that tracks an index.

Take for example the first ever index fund available to individual investors, the Vanguard 500 Index Fund (originally called the Vanguard Index Trust)—created in 1975 by John C. Bogle, who is the founder of Vanguard and the father of Passive Index Investing.

The Vanguard 500 Index Fund is a mutual fund that uses the S&P 500 index as a benchmark and thus seeks to track its performance. Meaning the Vanguard 500 Index Fund grows and falls with the S&P 500 index.

Here’s how John Bogle sums up the index fund in his classic investment book Common Sense on Mutual Funds, page 174:

The index fund is a most unlikely hero for the typical investor. It is no more (nor less) than a broadly diversified portfolio, typically run at rock-bottom costs, without the putative benefit of a brilliant, resourceful, and highly skilled portfolio manager. The index fund simply buys and holds the securities in a particular index, in proportion to their weight in the index. The concept is simplicity writ large.

3: Passive management

Passive Index Investing starts from the premise that it’s extremely difficult to “beat the market” consistently over long periods of time, and amazingly difficult once you factor in investment costs. And as such passive management is primarily built around low cost broad-based or all-market index funds (e.g., the Vanguard Total Stock Market Index Fund or iShares Core S&P 500 ETF)—the goal being to capture the returns of the respective market.

Passive management stands in contrast to active management. And the difference largely lies in the manager.

The passive manager suspends judgement about the world, and chooses an index as a benchmark, say a U.S. Stock Market index, and builds a fund around that index. The passive manager does not say “I’m going to create a fund that outperforms the U.S. Stock Market.” Rather he says, “I’m going to a build a fund that matches the U.S. Stock Market.”

The active manager on the other hand makes judgements about the world. He says, “Based off my research and expertise, I’m going to create a fund that outperforms the U.S. Stock Market.”

Here’s a breakdown of the differences between passive (index) and active funds:

4: Low costs

Low costs go with Passive Index Investing like peanut butter goes with jelly because, on average, the costs to manage an index fund are much less than those of an active fund. Why is this so? Again because of the manager.

In an active fund, you pay a premium for everything in the “Approach” section of the table above. The research, market forecasting and “expertise” of portfolio managers cost big money. And so this is a gigantic cost removed from the equation with passive index funds because the passive manager doesn’t go out of his way to come up with “strategy” to beat the market—he takes his cue from the index. And works to be the index.

When John Bogle created the index fund, he knew he had a strong idea but he might not have anticipated the revolution in investing he would spawn. A revolution highlighted by the downward pressure Passive Index Investing has put on fund companies to lower fund fees across the board, a huge benefit to all investors—passive and active.

But while we sing the praises of low investment costs, it’s always important to remember there is no such thing as guaranteed returns in investing, including Passive Index Investing. Remember: investing is a caveat emptor (buyer’s beware) world.

Notes:

• Remember that all investments are subject to risk, including the possible loss of the money you invest.
• And the performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.