Han Dieperink: Index investing is more active than you think

February 18, 2025

_{This column was originally written in Dutch. This is an English translation.}

By Han Dieperink, written in a personal capacity

Many investors see index investing as a completely passive strategy lacking any vision. It is often presented as a simple way of investing that requires no time or energy to make investment choices. Admittedly, I may have contributed to this myself with one of my columns about do-it-yourself investing ten years ago. The reality is more complex, however. Index investing does require important choices and presents specific challenges.

The first challenge is the selection of the index itself. Even an extensive index like the AEX, which will soon have 50 shares, may be too limited for a well-diversified portfolio. There are various ways to determine the weighting of index components, such as equal weighting, weighting based on market capitalisation or distribution per country based on GDP.

Furthermore, it is debatable whether currencies should be partially or fully hedged. The choices regarding the composition of the various indices are often made by commercial organisations such as Standard & Poor's, MSCI and FTSE, which can also take political considerations into account. For example, countries such as South Korea and Taiwan remain emerging markets for some organisations for a very long time, while others see these countries as developed markets.

An important characteristic of index investing is that it is in fact a form of momentum investing. Index investors mainly buy companies that have already done well in terms of share price - the well-known winners of the past. This is reinforced by the growing flow of money into index funds, making popular indices even more popular. This mechanism makes index investing the most widely followed strategy, but at the same time increases the risks. An active investor who sees through this process can therefore beat other indices with an index.

The risks of investing in the index become visible in extreme sector weightings, among other things. History shows that sectors are particularly attractive when they have a relatively low weighting compared to the historical average, while the risk is high when a certain sector has an extremely high weighting. For example, the IT sector peaked during the dotcom bubble, and many index investors would have preferred to have fewer financial institutions in their portfolios just before the 2008 financial crisis.

The country diversification within indices is not always optimal either. The current world stock index consists largely of American shares. This need not be a problem as long as these shares continue to perform well, but can lead to significant deviations if the American market lags behind. A similar situation occurred with Japanese shares, which made up almost 50% of the world index in the late eighties but now only make up about 5%.

Furthermore, many subjective choices are made within indices. For example, weightings are corrected for free float, which can lead to remarkable situations. Heineken, for example, carries less weight because a large portion of the shares are in fixed hands. For index investors, Heineken (free float 48%) is therefore less relevant than the smaller Constellation Brands (free float 96%), although that may not be the reason why Warren Buffett recently acquired a stake in the American brewer. However, this free-float correction is not applied to bonds, even if central banks have bought large quantities in the past.

The trend towards sustainable investment has led to new forms of active choices within indices. Some indices are reweighted based on sustainability criteria, while others exclude certain sectors entirely. These choices are often based more on social considerations than on market principles.

A common argument for index investing is that investing is a zero-sum game. This is not true, however: companies create value, which leads to economic growth and higher dividends. It is therefore possible that there are more winners than losers. Index investors benefit as ‘free riders’ from the choices of active investors.

The large number of components in global indices often leads to reduced transparency. Although some see this as the ultimate diversification, good diversification can also be achieved with fewer components. The resulting forced outsourcing via ETFs or index funds also makes it more difficult to gain detailed insight into the portfolio. This is despite the fact that such insight is increasingly demanded of investors and regulators.

Perhaps the most important point is that index investing is not a truly passive strategy. A truly passive approach would have to include all available investment opportunities, including private markets such as real estate, private equity and infrastructure. Private markets are much larger than the listed markets, but are completely ignored by index investors. The global stock market, for example, is worth over 100 trillion, and bonds approximately 130 trillion. These figures pale in comparison to the approximately 500 trillion in real estate, 200 trillion in private equity, 100 trillion in private debt and 200 trillion in infrastructure. The latter figures are of course an approximation, also because a large part is ‘in steady hands’.

Index investing started as an innovation that lowered the costs of active management. However, it has grown into a momentum strategy that was especially successful for self-reinforcing effects as a result of the still strong inflow. The current indices are dominated by large technology companies on the one hand and a large group of zombie companies on the other. Active investors can avoid the specific risks of index investing and achieve better risk-adjusted returns through conscious choices and a clear vision.

The conclusion is clear: despite its apparently passive nature, index investing requires significant active choices and involves specific risks. A truly passive strategy would have to include a much broader spectrum of investments. Successful investors understand these dynamics and make well-considered choices in their investment approach.

More columns by Han Dieperink