This is Part 7. Follow links for Part 1, 2, 3, 4, 5 and 6.
One of the most interesting aspects of the passive investing debate is not the evidence itself but the definitions used to draw the conclusions.
Throughout this series, we have examined whether broad market-cap-weighted index funds, such as VT, should automatically be considered the optimal passive investment strategy. A recurring theme has emerged: many arguments in favor of total-market indexing depend less on theoretical and empirical evidence and more on how the word passive is defined.
A recent example appears in Vanguard’s position paper Setting the Record Straight: The Truths About Index Fund Investing. On page 6, Vanguard states:
“A truly passive portfolio would be one that tracks a total market index. Even a portfolio that holds a large-cap growth index fund to capture exposure to U.S. equities would be an active portfolio relative to the U.S. total market.”
The statement appears straightforward. However, the supporting references reveal an important chain of reasoning that deserves closer examination.
The Proxy Failure
The first of Vanguard’s cited references is:
Gaba, Bender, Murphy, and Tucker (2024), Casting a Wide Net: Why True Passive Strategies Are Rare Catches.
The SSRN version of the paper is currently unavailable (This paper is under review or has been removed from SSRN at the request of the author, SSRN, or the rights holder.), but the abstract remains accessible. It contains the following statement:
“This article argues that only the theoretical market portfolio is a ‘purely’ passive catch, and in practice only index portfolios that track broad market-cap-weighted indices (‘passive-adjacent’) can be viewed as passive investing. Everything else is active.”
Notice what happened.
Because the theoretical market portfolio, which invests in all risky assets in market proportion, cannot actually be held, the authors substitute a broad market-cap-weighted stock index as a practical proxy.
This substitution is rarely discussed, yet it is the critical step upon which the entire argument depends.
Goltz and Le Sourd challenged the market-cap-weighted index fund’s claim to being the uniquely optimal passive portfolio, identifying two fatal flaws. First, the CAPM relies on a set of unrealistic assumptions that do not hold in actual markets. Second, the theoretical market portfolio is unobservable, forcing practitioners to substitute imperfect proxies. If the theory depends on assumptions that fail in practice and the portfolio itself cannot be observed, the claim that a total-market index represents the uniquely Theoretical Total Market as a proxy portfolio becomes difficult to sustain.
Active Relative to what Benchmark?
The second Vanguard-cited paper takes the argument further.
In How Investors Use Passive for Active, Vanguard researchers Jan-Carl Plagge, Haifeng Wang, and James Rowley, all prominent researchers from Vanguard’s Investment Strategy and Quantitative Equity groups, propose the following definition of Active: any strategy or aggregate portfolio allocation that deliberately departs from a broad, market-capitalization-weighted total market.
Under this framework:
- Overweighting small-cap stocks is active.
- Underweighting large-cap stocks is active.
- Excluding international stocks is active.
- Tilting toward value stocks is active.
The justification relies primarily on two concepts:
The problem is that both foundations have been challenged.
Goltz and Le Sourd question whether a market-cap-weighted index fund deserves its privileged status as the optimal passive portfolio in the first place.
Meanwhile, Lasse Heje Pedersen has pointed out limitations in the traditional interpretation of Sharpe’s Arithmetic. The original framework assumes a static universe in which the aggregate market portfolio is fixed and all deviations can be measured against it. Real markets continuously change through IPOs, delistings, capital formation, buyouts, private markets, and investor cash flows.
The neat distinction between “the market” and “deviations from the market” becomes much harder to maintain once these dynamics are acknowledged.
Definitions or Conclusions?
Suppose we reject the basic operational definition that the Vanguard authors used as their baseline, for the above good reasons, then what remains of the argument?
Consider the structure:
- Define a total-market-cap index as the passive benchmark.
- Define any deviation from that benchmark as active.
- Observe that investors deviate from the benchmark.
- Conclude that investors are active.
The benchmark is privileged by definition, not by evidence. The conclusion follows directly from the definition.
But “the definition” is not evidence that the benchmark itself deserves special status.
It merely shows that investors are not holding the benchmark. That is a measurement relative to an arbitrary social convention, not a physical constant.
The distinction is important.
In physics, a meter is meaningful because it is tied to a physical standard.
In finance, the total-market index is not a physical constant. It is a convention derived from the theoretical CAPM model and a total market index fund is an imperfect proxy for it.
Once that distinction is recognized, measuring “activity” relative to the benchmark becomes less of a scientific observation and more of a classification choice.
The Same Logic Appears Again
In the third cited reference James Rowley reiterated the same framework in his 2024 guest editor’s letter for The Journal of Beta Investment Strategies.
He offers the following example:
An investor holding a total market index fund plus a small-cap value index fund would be considered active relative to the U.S. market.
Meanwhile, an investor holding only traditional active mutual funds could potentially be classified as less active if the aggregate portfolio exposure happens to resemble the total market more closely.
Notice that no security selection skill, forecasting, research effort, or prediction is required for the first investor to be labeled active.
The label arises solely because portfolio weights differ from the chosen benchmark.
Again, the conclusion depends entirely on accepting the benchmark’s privileged status.
Without that assumption, the classification loses much of its force.
From Academic Definition to Industry Dogma
What begins as an academic definition often becomes accepted wisdom.
A few months ago, a video of veteran financial expert Rick Ferri presented this Vanguard framework to a group of Bogleheads, treating the total-market benchmark as the natural reference point for distinguishing passive and active investors. No one questioned whether the benchmark deserves that status.
This is how ideas spread through the investment community.
- A theoretical construct becomes a benchmark (CAPM → market portfolio).
- The benchmark becomes a definition.(cap-weighted index = passive)
- The definition becomes the conclusion.(everything else = active)
- The conclusion is reinforced on social media.(Rick Ferri at Bogleheads)
Eventually, questioning the benchmark itself begins to sound controversial even though it is the most important assumption in the entire chain.
The Real Question
The debate of whether investors who differ from broad market index funds are “active” is misplaced
The first principles question is whether a broad market index fund deserves to be treated as the neutral reference point in the first place.
If the theoretical foundations upon which choosing such a reference point are weak and the replacement of that point with a total market index as a practical proxy is imperfect, then the passive-versus-active distinction becomes less objective than many investors assume.
At that point, the discussion shifts to semantics.
And once the debate becomes semantic, labeling every deviation from a broad market index fund as “active” tells us very little about whether those deviations are rational, irrational, beneficial, or harmful.
It merely tells us how the benchmark was defined.
Disclaimer: This blog post is for informational purposes only and should not be considered financial advice. Past performance is not a guarantee of future results. Consult with a qualified financial advisor for personalized guidance.
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