With Generalist Robo-Advisers trumpeting the virtues of passive investing, and attracting a lot of money, it’s now more important than ever to take a fresh look at what so-called this approach is really about. And when we do, we’ll see that deep down, it’s as active as anything else but spun in such a way as to allow advisers to say “don’t blame me, it’s the market.”

What, exactly, is passive investing?

Simply, passive investing means buying the whole market rather than choosing individual assets or even individual categories such as sectors, countries, and so forth.

Right way we’ve got a problem? What, exactly, is “the market?” It might be the S&P 500 (which, nowadays, is easily buyable through a variety of ETFs designed to track it closely). But that only addresses stocks. There are other asset classes. But that may be the least of the problems. Let’s assume, for now, that we want to be passive equity investors. Even so . . .

Buying the S&P 500 is not a Passive Investment

In truth, a stake in the S&P 500 is an active bet on the performance of U.S. large-cap stocks with a momentum bias.

You might not consciously think along these lines if, for example, you own SPDR S&P 500 ETF (SPY) or the Vanguard S&P 500 ETF (VOO). But whether you consciously think about it or not, the fact is that the S&P 500 consists of large capitalization U.S. stocks, as can be seen if one examines S&P’s methodology. The momentum bias is inevitable given that the securities in the index are market-capitalization weighted, a situation is not changed even by S&P’s proprietary approach to cap weighting (see this article for a demonstration of why this is so).

It would be one thing if you say, straight up, I like U.S. large cap-momentum and want to emphasize that in my portfolio. I don’t necessarily have a problem with such a choice (often, this set of choices performs quite well). I do, however, suggest there’s a huge problem with a thought process that backs into this, or other similarly important risk exposures, unwittingly rather than thoughtfully. A half-hearted purchase of SPY or VOO won’t likely blow up your portfolio. But a habit of investing without knowing the risks to which you are exposed, if maintained, could easily turn into a slippery slope down which your portfolio may slide.

A More Comprehensive Definition of Passive Investing

Vanguard, a prominent proponent of passive investing (notwithstanding that its ETF family offers considerable opportunity and temptation to invest actively by choosing among its many different kinds of “index” funds) frames the approach as one in which the investor owns a market-capitalization weighted index comprising all investable assets (i.e. not just the S&P 500, although, as noted, VOO tracks this index). Without bogging down in debates over what a more comprehensive definition of assets this should include (Does it require inclusion of every publicly traded asset on Planet Earth, God’s investment portfolio?), let’s continue for now to focus on U.S. equities.