The Active vs. Passive Distinction Is Broken — And It Matters

Why lumping factor funds with stock-pickers distorts the scorecard and misleads investors

Every year, S&P Global publishes its SPIVA scorecard — the industry’s most-cited benchmark for how “active” funds perform against “passive” ones. The methodology is straightforward: index funds are passive; everything else is active. It is also, by that same straightforwardness, too blunt to distinguish meaningfully different kinds of strategies.

Under the SPIVA framework, a fund run by Dimensional (DFA), Avantis, or BlackRock may systematically tilt toward factors such as size, value, and profitability/quality in small-cap stocks. The rules are defined in advance, applied consistently, and executed with virtually no portfolio manager discretion.

Yet it is grouped with a hedge fund whose manager makes concentrated bets on individual companies and times entries around earnings calls. That is a category error so large that it renders much of the analysis misleading.

What does “active management” actually mean?

The cleanest definition I have encountered comes from Eugene Fama. In a presentation I attended, he defined active management as individual stock selection and/or market timing. Fama is arguably the most important living figure in financial economics, and a foundational figure in factor investing.

That definition cuts through a lot of noise. Active management is an attempt to identify which securities will outperform and when to be in or out of the market. It is the exercise of human judgment in deciding which stocks to hold, and when to hold them.

By that standard, much of what the industry calls “passive” deserves scrutiny. And much of what it calls “active” belongs in a different category.

The S&P 500 is not purely passive — it is systematic

Consider the S&P 500 index. It is administered by a committee at S&P Global that meets regularly and votes on which companies to include or exclude. Inclusion is not mechanical. There are criteria — profitability, liquidity, domicile, float — but within those criteria, human beings make judgment calls. The index does not contain the 500 largest U.S. companies by market capitalization. It contains 500 companies chosen by a committee that exercises discretion.

The same is true of the S&P MidCap 400 and SmallCap 600. The 600, notably, screens for profitability — a factor screen every bit as deliberate as what academic factor funds do. The committee decides what goes in. One might argue there is no individual stock selection here — but of course there is. It simply happens “upstream” — it is done at the index construction level rather than by a portfolio manager daily.

Now take a DFA or Avantis fund. The investment team defines a universe: perhaps the bottom 10% of market capitalizations, intersected with the top 30% ranked by book-to-market ratio. That universe is constructed systematically, from academic factor definitions, with rules that are public, transparent, and applied mechanically. No portfolio manager makes security-by-security judgment calls. No one times the market. Within the defined universe, the fund holds securities in proportion to their weights. That is not active management by Fama’s definition. And it resembles what the S&P committee does: both are rules-based, though one relies more on committee judgment at the index-construction stage while the Dimensional and Avantis funds are more academically rigorous in how they define their universe.

The old binary

• Index funds → passive

• Factor → active

• Stock pickers → active

• Macro timing funds → active

A better framework

• Stock selection / timing → active

• Rule-based, discretionary index → systematic

• Factor funds (DFA, Avantis) → systematic

• Total market index → systematic

The right framework: active versus systematic

The better distinction is not between “index” and “non-index.” It is between strategies that rely on human judgment in security selection or market timing and strategies that follow pre-specified, transparent rules.

The second category deserves its own name. Systematic, transparent, and replicable captures it well. A strategy earns that label when:

1. The rules are defined in advance. The universe and weighting methodology are specified before any trade is made, not adjusted in response to manager views.

2. The rules are transparent. Any investor can understand exactly what the fund will and will not hold, and why.

3. The rules are consistently applied. Execution follows the methodology without discretionary overrides. No stock is added or subtracted because a manager likes or dislikes its story.

4. There is no market timing. The fund stays invested according to its mandate regardless of macro views.

Under this framework, all index funds are systematic. A Dimensional small value fund is systematic. An S&P 500 index fund is mostly systematic (though the committee introduces a degree of human judgment at the construction level that is absent in cap-weighted total market vehicles, it is systematic in its implementation). A concentrated stock-picking hedge fund is active. A tactical allocation fund that moves to cash when its manager gets nervous about valuations is active.

Why this matters more than semantics

The misclassification is not merely a pedantic complaint. It has real consequences for how investors interpret performance data and make allocation decisions.

When SPIVA reports that 85% of “active” large-cap funds underperform over 15 years, what it is mostly measuring is the difficulty of stock selection and market timing — the persistent drag of transaction costs, behavioral errors, and the arithmetic reality that not every manager can beat the average. That finding is correct and important.

But lumping systematic factor funds into the same category muddies the picture. A Dimensional fund that tilts toward value and profitability is not trying to beat the market, or some index, through stock selection. These are not arbitrary tilts. The factors that systematic funds target share well-documented properties that have decades of theoretical and empirical support showing evidence of premia that are:

· persistent across economic regimes

· pervasive across sectors, countries, regions, and even where appropriate asset classes

· robust to various definitions

· survives transactions costs

· have either risk- or behavioral-based explanations for why the premiums should persist.

The performance of a Dimensional fund relative to a cap-weighted index will be driven by whether those factors have positive returns over the measurement period, not by whether a manager’s stock picks were successful.

Comparing a small value factor fund to the S&P 500 or even the S&P 600 and calling the result an “active vs. passive” contest misrepresents both the strategy and the question as their eligible universes can be quite different. In other words, comparing them is measuring factor exposure, not manager skill.

Implications for how we talk about investing

The industry’s vocabulary has not kept pace with its intellectual development. The academic research on factor investing has been mainstream for decades — the Fama-French three-factor model dates to 1992. Yet the reporting and regulatory frameworks still use a binary that collapses a rich spectrum of strategies into two buckets defined by whether a fund tracks a named index, rather than by what the fund is actually doing.

Advisors and investors would be better served by asking more precise questions. Not “is this fund active or passive?” but: Does this strategy involve individual stock selection? Does it involve market timing? Are the rules transparent and consistently applied? Is there a theoretical and empirical basis for the factor exposures being sought?

A fund that answers no to the first two questions and yes to the last two is not active management in any meaningful sense. It is systematic investing — and it deserves to be evaluated on its own terms.

The key distinction, simply stated: Active management means someone is deciding which specific securities to own, or when to be in or out of the market, based on judgment. Systematic investing means a defined, transparent, consistently-applied ruleset does the work — with no human judgment intervening at the stock selection or timing level. Most factor funds belong in the second category. Lumping them with stock-pickers is an error that misleads investors and distorts the evidence.

Eugene Fama’s definition is not just clean — it is useful precisely because it strips away the institutional scaffolding (index vs. non-index, ETF vs. mutual fund) and asks the only question that actually matters about investment process: is a human being making judgment calls about which stocks to own and when?

The sooner the industry adopts that question as its standard, the better served investors will be.

Larry Swedroe is the author or co-author of 18 books on investing, including his latest Enrich Your Future. He is also a consultant to RIAs as an educator on investment strategies. This article is for informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice.