Index investing is wildly popular with Americans: As of year-end 2014, “passive” index funds managed total net assets of $2.1 trillion, according to the Investment Company Institute.

As passive investments, index funds are supposed to closely track the performance of a market benchmark such as the S&P 500 index. Fund management has no need to actively make investment choices. But as we’ll explain, passive investing can be very different between theory and reality.

Vanguard Group founder John Bogle launched the first index fund for investors in 1976, and his book Common Sense on Mutual Funds convinced a whole generation that active management was a loser’s proposition after fees were deducted.

It’s widely understood that index funds and other passive investments own the same underlying stocks consistently, with changes being exceedingly rare. But the truth is that passive investing is a misnomer, at best – and is misleading at worst.

Let’s look at funds based on the S&P 500 index, such as the Vanguard 500 Index Fund and the S&P 500 SPDR Exchange-Traded Fund (ETF). These purportedly passive funds have, in fact, chosen the S&P Dow Jones team that oversees the S&P 500 index to provide what is essentially active management. Here’s what we mean:

The components of the S&P 500 index can and do change based on rules concerning momentum and fundamental factors. Changes can even be made on a subjective basis via a committee process. Few investors understand just how often changes are made! Between January 2005 and January 2015, 188 of the S&P 500 index components were replaced by other components.

Indeed, our research shows that there are fewer than 70 companies in the present-day S&P 500 Index that were even trading publicly 35 years ago, let alone included in the S&P 500 at that time.

Perhaps more surprising than the fact that the S&P 500 Index and its associated funds are “active management in disguise” is research suggesting that the S&P 500 Index Fund has actually underperformed a less actively managed index – namely its prior self. According to a study performed by professor Jeremy Siegel, author of the famed Stocks for the Long Run, “the more than 900 new firms added to the index since it was formulated in 1957 had, on average, underperformed the original 500 firms in the index … Investors were better off had they bought the original S&P 500 firms in 1957 and never made any changes to their portfolio.”

Now you might be thinking, Hmm . . .  since the committee who selected the stocks for the S&P 500 in 1957 did better than the subsequent and ever-changing S&P 500 Index Fund and a large number of active fund managers since that time, maybe an active stock selection, lower turnover strategy is better than a more active one.

To us, the results mean that an active stock selection process will always be a key determinant of long-term equity investment returns, even under seemingly “passive” strategies. It turns out that indexers really aren’t passive investors, but deliberate investors just like us.

If you would like help understanding what you’re really invested in, we may be able to help. At Intelligent Capitalworks, that’s just part of what we do.

If you would like to read our more detailed comments about the active management behind the S&P 500 Index, please send your request to: [email protected] and we will forward our comments to you:

The Shocking Truth About Indexing
You may not believe it until you read it, but it’s true.