Why “Just Buy the Index” Isn’t the Whole Story

Investing Series — Part 2 of 3

In part one of this series, we made the case against active management: net of fees, the vast majority of actively managed funds fail to beat their benchmark, consistently, across markets and decades. The natural next step most people land on is “fine — just buy the index.” Part two is about why that’s a good instinct, but a much less simple one than it sounds.

Passive investing, defined

Passive investing means buying a fund built to track an index as closely as possible, with no attempt to pick winners or time the market. Two separate parties are involved: an index provider (S&P, MSCI, Dow Jones, Russell, and others)that defines and maintains the index — deciding which companies belong in it —and a fund provider (Vanguard, BlackRock, or your bank’s e-Series funds, for example) that builds a product designed to mirror that index as closely as possible.

Here’s the number that reframes the whole conversation: there are roughly 13 million indexes tracked worldwide. Whatever idea or slice of the market you can imagine, there’s probably an index for it already. Which means before you can even be a “passive investor,” you have to make an active choice — which index, out of millions, are you actually trying to mirror?

The decisions hidinginside “passive”

That index choice isn’t the only one. A look at US small-cap stocks makes the stakes clear: three well-known small-cap indexes (from S&P, Russell, and CRSP),all with essentially the same mandate, produced annualized returns that differed by about 5 percentage points over the last 20 years. Picking the “wrong” small-cap index, in other words, can matter enormously.

And the decisions stack up from there: what index to track, which fund manager to use to track it, your overall asset allocation between stocks and bonds, how much home-country bias to carry versus international exposure, and which account type to hold it all in. None of that is passive in the sense of “no decisions required.” It’s a different set of decisions than active stock-picking, but it’s still a set of decisions — and getting them wrong has real, measurable costs.

Two storiesabout how indexes actually work

Lululemon’s five-year wait. Indexproviders set criteria for what gets added to an index — for the S&P 500,that generally means sufficient market size and multiple consecutive profitablequarters. Lululemon crossed the S&P 500’s size threshold back in 2018, whenit carried a $17 billion market cap. It kept growing — $49 billion by September2020, and a peak of $56 billion in December 2021, which would have placed it inthe top half of the entire index by size. It still wasn’t added. Lululemondidn’t actually join the S&P 500 until October 2023 — nearly five yearsafter it was arguably large enough to belong. The addition isn’t automatic;it’s a discretionary decision made by a committee, on their own timeline. (In2003, the S&P 500 committee reportedly declined to add Google outright, atthe time citing a belief that “what goes up must come down” — a strikinglyactive, technical-analysis-style call from a supposedly passive index.)

Tesla’s month of forced buying. WhenTesla finally met the S&P 500’s profitability requirement, its addition wasannounced roughly a month before it actually happened — set for December 2020.Over those four weeks, with no change in earnings or company news, Tesla’sshare price ran from about $130 to $230, even as the broader market rose onlyaround 4% over the same stretch. The reason: every S&P 500 index fundmanager knew, with certainty, that they’d be required to buy Tesla shares — atwhatever the price happened to be — on the exact day it joined the index, inorder to keep their tracking error near zero. Active managers, who had a fullmonth’s notice of exactly what the passive funds were mandated to do, couldposition ahead of it. It’s the investing equivalent of buying roses on February14th: everyone’s buying at the same moment, for the same reason, and the pricereflects that.

“Passive” and “ETF”aren’t the same thing

A common shortcut — mutual funds are the bad, high-fee option, ETFs are the good, low-fee, passive option — doesn’t hold up. An ETF is simply a wrapper, a vehicle for buying exposure to something; it says nothing on its own about whether the strategy inside is active or passive. Roughly 23% of all dollars invested in ETFs are actually in actively managed ETFs, even as Canadian ETF assets have grown by 653% over the last decade.

Fees follow the same nuance. Actively managed mutual funds (or segregated funds)commonly run 2% to 3.5%+ in fees. Actively managed ETFs are usually somewhat cheaper than that, but still meaningfully above a passive option. A well-diversified passive ETF typically runs around 0.20–0.25%. And — the detail that breaks the “mutual fund bad, ETF good” shortcut completely — some low-cost, well-diversified passive-style mutual funds land in that same0.28–0.29% range. The vehicle isn’t the thing that determines the cost or the strategy; what’s actually inside it is.

The bottom line

Passive investing stillcomes out ahead of active management for most investors — that conclusion frompart one hasn’t changed. But “passive” doesn’t mean decision-free, and it’sworth remembering that neither the index provider nor the fund company isoptimizing for your outcome. Their job is tracking accuracy and market share,not your personal return. Every one of those quiet, structural decisions —which index, which fund, how trades get forced through on a set date — carriesa real cost that rarely gets discussed.

That raises the obviousquestion for part three: is there a way to keep what’s genuinely good aboutindexing — broad diversification, low cost, transparency, evidence-based design— while avoiding the parts that quietly work against you, like being forced tobuy Tesla at its most expensive price of the month? That’s exactly where we’reheaded next.

This is part 2 of a3-part series. [Listen to episode 034 of The Chiro Money Show →]

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