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In the ongoing debates about the virtues of active versus passive investment strategies, a fundamental problem undermines meaningful discussion: there is no universally accepted definition of what constitutes a “passive” strategy. This definitional confusion creates artificial distinctions that obscure more important considerations for investors.

The Classification Paradox
 

Consider how major fund analysts categorize investments. Morningstar classifies all index funds as passive, while funds from companies like Dimensional Fund Advisors and Avantis are labeled as active. Yet, when we examine how these funds actually operate, this distinction becomes largely meaningless—a classic case of “a distinction without a difference.”⁽¹⁾

The Index Selection Fallacy
 

To illustrate this paradox, let’s examine Vanguard’s approach to small cap investing. The company offers the S&P Small Cap 600 ETF (VIOO), which tracks the S&P 600 Small Cap Index. However, this represents a clearly active decision by Vanguard’s management team. They could have chosen from numerous other small-cap indices with different construction methodologies:

• Russell 2000 – The most widely followed small-cap benchmark
• CRSP US Small Cap Index – Used by Vanguard’s own VB ETF
• MSCI USA Small Cap 1750 – Vanguard used this until January 30, 2013, when it switched to the CRSP Index. 

The fact that Vanguard operates VB, which tracks the CRSP US Small Cap Index with entirely different construction rules than the S&P 600, and used the MSCI 1750 prior to the switch, proves that index selection is an active strategic choice.

Comparing Construction Methodologies
 

S&P 600 Index Rules

S&P Dow Jones Indices employs specific, active criteria for the S&P 600:

• Market capitalization requirements within defined small-cap ranges.
• Float-adjusted weighting—only shares available for trading count towards the index weight.
• Financial viability standards requiring demonstrated profitability.
• Liquidity thresholds ensuring adequate trading volume.
• Sector balance considerations to reflect broader market composition.
• Quality screens that exclude “penny stocks” and financially distressed companies.

Importantly, the S&P Index Committee meets regularly to review additions and deletions, considering both quantitative metrics and qualitative factors. These are unambiguously active management decisions.

CRSP US Small Cap Index Rules

By contrast, the CRSP index uses different construction principles:

• Percentile-based sizing (85th to 98th percentiles of market capitalization).
• Float-adjusted weighting with effective float factors.
• Packeting methodology for gradual migration between size categories.
• Investability screens including trading volume and market cap thresholds.
• Systematic reconstitution on predetermined quarterly schedules.

Both methodologies involve active choices about what constitutes an appropriate small-cap investment universe, yet both are typically classified as “passive” once implemented.

The Dimensional Comparison

Now consider Dimensional Fund Advisors’ approach with their US Small Cap ETF (DFAS). Like the S&P 600, DFAS doesn’t rely solely on size criteria. The fund incorporates:

• Profitability screens (operating income before depreciation and amortization minus interest expense, scaled by book value).
• Momentum factor systematically applied.
• Buy-and-hold ranges to minimize unnecessary turnover.
• Patient trading algorithms to reduce market impact costs and avoid front-running.

Crucially, once Dimensional establishes these construction rules, the fund operates without individual security selection or market timing decisions—identical to how VIOO operates within the S&P 600 framework.

The Real Distinction That Matters
 

The key insight is that both VIOO and DFAS are managed systematically, transparently, and replicably. The only “active” decisions occur when establishing the initial construction rules—which is equally true for traditional index funds.

Yet, Morningstar classifies VIOO as passive (because it is an index fund) and DFAS as active, creating a false dichotomy that obscures their fundamental similarities. Both funds:

• Follow predetermined, systematic rules
• Do not make discretionary decisions regarding security selection.
• Implement no market timing strategies
• Operate with full transparency about their methodologies
• Can be replicated by any investor with access to the same construction rules

A Better Framework for Investors

Rather than getting caught up in arbitrary active/passive labels, investors should focus on more meaningful distinctions:

Systematic vs. Discretionary Management

• Does the fund follow predetermined rules, or do managers make subjective decisions?

Transparency vs. Opacity

• Are the fund’s construction rules fully disclosed and replicable?

Cost Structure

• What are the total costs of implementation, including management fees and trading costs?

Risk Factor Exposure

• Which systematic risk factors (size, value, profitability, momentum) does the fund target?

Implementation Quality

• How effectively does the fund translate its methodology into actual portfolio construction? Does the fund trade patiently and avoid the costs of index replication?

Conclusion
 

The active versus passive debate, as currently framed, creates more confusion than clarity. Instead of perpetuating false distinctions, investors, and analysts should recognize that most successful investment strategies—whether labeled “active” or “passive”—share common characteristics: systematic implementation, transparent methodologies, and disciplined adherence to evidence-based construction rules.

The real question isn’t whether a fund is active or passive, but whether its systematic approach is grounded in sound investment principles and implemented cost-effectively. This reframing moves us beyond semantic debates toward more productive discussions about investment strategy and portfolio construction.

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