Index funds may be more active than you think

By Karen Umland, CFA, Senior Investment Director and Vice President at Dimensional Fund Advisors

Numerous active decisions go into the design and management of indices. Index fund investors should evaluate whether such decisions align with their objectives.

Index funds are widely viewed as a way for investors to achieve broad, passive exposure to certain markets or asset classes. However, investors may overlook the fact that the creation and maintenance of an index fund entails numerous active decisions. Indeed, index providers make many choices that have important implications for the characteristics and returns of the benchmarks they produce.

We can see this in how indices designed to target the same asset class can often have disparate returns.

In a research paper titled “Indices Acting Active,” we looked at the annual returns of three US small cap indices over the 20 years ending in 2023 (see Exhibit 1).¹

The average return difference between the best and worst performer was 4.9 percentage points, and in some years that difference was markedly higher. For example, in 2009 and 2021, the return of the best-performing index exceeded that of the worst-performing index by more than 10 percentage points.

Return variations of this magnitude may be more commonly associated with active strategies than with indices passively tracking the same asset class.

This observation is not unique to small cap indices. Perhaps surprisingly, even indices designed to represent the total US market can behave differently from one another. Over the 20-year period ending 31 December 2025, the annual difference in returns between the best and worst performer among four total US market benchmarks ranged from 0.2  to 3.2 percentage points, with an average of 1 percentage point per annum (see Exhibit 2).

These return differences underscore the reality that no single approach exists to defining a market. According to the Investment Company Institute: “Index construction and administration often involve a significant number of assumptions, inputs, rules, and methodological choices.”² Among these are which stocks and countries to include, what weights to give them and when to add them.

How Are Stock Eligibility Decisions Made?

Index providers must determine which group of stocks best represents a market or asset class, as well as when the stocks are added, when they are dropped and at what weight they are held. These decision points can add up to significant differences in stock exposure between two indices that purport to cover the same asset class or market.

For instance, investors might expect that determining what constitutes a large cap stock in the US is a routine process. However, the timing of Tesla’s inclusion in the S&P 500 Index serves as an illustration that this expectation may not hold true. In January 2020, Tesla’s stock was trading at approximately $40 per share, making it roughly the 60th-largest company in the United States by market capitalisation. However, at that time, Tesla had not yet met all the eligibility criteria for the S&P 500, such as the stipulation that constituents have positive income over the trailing 12 months, including the most recent quarter.

Later that year, in November, S&P Dow Jones announced that Tesla was eligible and would be added to the S&P 500 in December. Meanwhile, over the course of 2020, Tesla’s stock price increased. By the day before its addition, Tesla’s stock was worth approximately $200 per share, making it the sixth-largest company in the US by market capitalisation.³

Missing out on Tesla’s returns for most of 2020 detracted from the returns of the S&P 500 in that year compared to those of US large cap indices that included the stock, such as the Russell 1000 Index. The Tesla example highlights the fact that differences in index methodologies can have consequences for returns in a manner similar to stock selection decisions by active managers.

How Are Country Decisions Made?

In the case of indices that comprise multiple countries, index providers also face the task of deciding which countries to include and what weights to assign them. Major providers of international indices often come to different determinations of which countries are developed versus emerging, leading to different underlying country exposures for indices targeting similar international asset classes. For example, at the end of 2023, South Korea represented 13% of the MSCI Emerging Markets IMI Index, making it the fourth-largest market in that benchmark, while it had no weight in the FTSE Emerging All Cap Index, as FTSE considers South Korea a developed market.

Other methodology decisions may also impact country weights, even for indices offered by the same provider. Country weights are often linked to the overall size of a country’s securities universe, so the methodology for selecting and including stocks can impact these weights. For instance, rules determining which stocks to consider large versus small can meaningfully affect country weights in large cap versus small cap indices. In the MSCI Emerging Markets IMI Index, which covers the full market-capitalisation spectrum from large cap to small cap stocks, China was the largest country at the end of 2023, with a weight of 24%. In the MSCI Emerging Markets Small Cap Index, India was the biggest country, with a 26% weight, and China represented only 7%, starkly smaller than its representation in the IMI index (see Exhibit 3).

Hidden Costs

Common practice has been to measure index fund managers by how closely they track their target indices. However, tracking error does not reveal the impact of methodology decisions made by index providers. If the index experiences style drift and the manager tracks the index perfectly, the opportunity cost is hidden within a low-tracking-error metric.

For example, an index fund may buy an addition to the index at the same price it enters. However, if the index provider has taken several months to include an eligible stock because it was waiting for its reconstitution date, then returns may have been missed in the meantime. Equally, if one index is slower to include a stock than its peers because it has stricter eligibility rules, then that will have a knock-on effect on the funds tracking it.

Index fund managers who focus on tracking their target benchmarks are essentially outsourcing decisions regarding the construction and maintenance of their portfolios to index providers. However, index providers themselves typically are not fiduciaries. Major index providers are usually independent third parties.

According to MSCI: “This fiduciary duty is fundamentally at odds with the role of the index providers in the capital markets ecosystem, which is to produce independent and rules-based information for use by market participants.”⁴ S&P Dow Jones echoes that sentiment: “Each index is designed in accordance with stated rules; it is not intended to meet the investment objective of any individual licensee or investor.”⁵

Overall, there isn’t one best approach to delivering market exposure, so, beyond tracking considerations, it is important for index investors to perform due diligence on decisions made by their index provider. As with any investment strategy, it is imperative to evaluate whether these choices align with and serve your investment objectives.

Footnotes: 

¹ Karen Umland, “Indices Acting Active: Index Decisions May Be More Active than You Think” (research paper, Dimensional Fund Advisors, February 2024).

² “Indexes and How Funds and Advisers Use Them: A Primer,” Investment Company Institute, January 2021.

³ Tesla stock price data from Bloomberg LP. Bloomberg data provided by Bloomberg.

⁴ Neil Acres, Managing Director and Global Head of Government and Regulatory Affairs, MSCI Inc., letter to US Securities and Exchange Commission, August 15, 2022.

⁵ Joe DePaolo, General Counsel, S&P Dow Jones Indices, letter to US Securities and Exchange Commission, August 16, 2022.

Disclosures

FOR PROFESSIONAL USE ONLY. NOT FOR USE WITH RETAIL INVESTORS.

The information in this material is intended for the recipient’s background information and use only. It is provided in good faith and without any warranty or representation as to accuracy or completeness. Information and opinions presented in this material have been obtained or derived from sources believed by Dimensional to be reliable, and Dimensional has reasonable grounds to believe that all factual information herein is true as at the date of this material. It does not constitute investment advice, a recommendation or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. Before acting on any information in this document, you should consider whether it is appropriate for your particular circumstances and, if appropriate, seek professional advice. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorised reproduction or transmission of this material is strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.

This material is not directed at any person in any jurisdiction where the availability of this material is prohibited or would subject Dimensional or its products or services to any registration, licensing or other such legal requirements within the jurisdiction.

“Dimensional” refers to the Dimensional separate but affiliated entities generally, rather than to one particular entity. These entities are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., Dimensional Ireland Limited, DFA Australia Limited, Dimensional Fund Advisors Canada ULC,

Dimensional Fund Advisors Pte. Ltd., Dimensional Japan Ltd. and Dimensional Hong Kong Limited. Dimensional Hong Kong Limited is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.

RISKS
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.

WHERE ISSUED BY DIMENSIONAL IRELAND LIMITED

Issued by Dimensional Ireland Limited (Dimensional Ireland), with registered office 3 Dublin Landings, North Wall Quay, Dublin 1, Ireland. Dimensional Ireland is regulated by the Central Bank of Ireland (Registration No. C185067).

WHERE ISSUED BY DIMENSIONAL FUND ADVISORS LTD.

Issued by Dimensional Fund Advisors Ltd. (Dimensional UK), 20 Triton Street, Regent’s Place, London, NW1 3BF. Dimensional UK is authorised and regulated by the Financial Conduct Authority (FCA) – Firm Reference No. 150100.

Dimensional UK and Dimensional Ireland do not give financial advice. You are responsible for deciding whether an investment is suitable for your personal circumstances, and we recommend that a financial adviser helps you with that decision.

Dimensional UK and Dimensional Ireland issue information and materials in English and may also issue information and materials in certain other languages. The recipient’s continued acceptance of information and materials from Dimensional UK and Dimensional Ireland will constitute the recipient’s consent to be provided with such information and materials, where relevant, in more than one language.

NOTICE TO INVESTORS IN SWITZERLAND: This is advertising material.