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Given my suggestion in last month's column that passive investing is the "default" standard for modern prudent fiduciary investing, I though it might be worthwhile to dispel some widely accepted myths of passive investing to help fiduciaries in their understanding.

Myth: Passive investing is risk-free.

Reality: Nobel Laureate Harry Markowitz observes: "Risk is risk." Since there's no guaranteed safe way to reap the rewards of investing in financial markets, passive investing is no panacea for escaping investment risk. Passive investing is, however, the best way to rid a portfolio of as much uncompensated risk as possible (and the only way of eliminating the risk of underperforming a given financial market).

But investing passively cannot eliminate the risk of losing money. No amount of diversification--whether done on an active basis or a passive basis--can reduce the compensated risk that's present in all investment portfolios. That's because such risk is inherent in all financial markets. The only way to avoid that kind of risk is to avoid investing.

Myth: Passive investing is investing just in S&P 500 index funds.

Reality: Many investors equate passive investing with investing just in S&P 500 index funds. When the stocks of the S&P 500 outperform some other well-known asset class such as small-company stocks, they seem to think that passive investing works. When those stocks underperform, many investors seem to think that passive investing doesn't work. The fact that the large-company stocks composing the S&P 500 underperform some other asset class, though, has nothing to do with the validity of passive investing. It just means that the stocks of that asset class failed to outperform those of the other asset class for the period in question.

Passive investing, then, means more than investing just in S&P 500 index funds. For example, passive investors can invest in funds tracking the entire U.S. stock market. Passive funds are also invested in small-company, midsize-company stocks, and emerging-markets stocks that represent discrete asset classes. Other passive funds provide the performance of asset classes reflecting specific investment styles such as "value" and "growth" stocks. Nor is passive investing limited to stocks. There are passive fixed-income funds that hold corporate bonds, Treasury bonds, or combinations of them with clearly defined standards of quality and maturity.

One of the reasons why passive investing is associated with the S&P 500 is that this benchmark is the most widely used to designate the U.S. stock market. In addition, the first index fund opened to individual investors tracked the S&P 500. At that time in 1976, the S&P 500 was the only part of the U.S. stock market that was sufficiently liquid to index. Since then, the U.S. stock market (as well as other non-U.S. financial markets) has become much more liquid.

Myth: Passive funds lose more money in market downturns than active funds.

Reality: Evidence indicates that active funds do not avoid losses in market downturns any better than passive funds. In fact, many active funds experience losses larger than those of passive funds.

An active manager seeks to hold a greater percentage of cash reserves at market highs, thereby exposing a smaller portion of its portfolio to declining values in subsequent market downturns. (Passive funds, in comparison, are required to remain fully invested so they are fully exposed to market downturns.) Conversely, an active manager seeks to hold a smaller percentage of cash reserves at market lows, thereby exposing a larger portion of its portfolio to increasing values during subsequent market upturns.

There's little evidence, though, that active fund managers have the foresight to either a) hold more cash reserves before market downturns or b) hold less cash reserves before market upturns. On the contrary, the evidence is clear that active fund managers consistently hold smaller percentages of cash reserves at market highs (thus exposing a greater percentage of fund assets to market declines) and larger percentages of cash reserves at market lows (thus exposing a smaller percentage of fund assets to market advances).