Passive ETF Definition

What is a passive ETF?

A passive exchange-traded fund (ETF) is a financial instrument that seeks to replicate the performance of the broader stock market or of a specific sector or trend. Passive ETFs mirror the holdings of a index—a collection of tradable assets believed to be representative of a particular market or segment. Investors can buy and sell passive ETFs throughout the trading day, just like stocks on a major exchange.

Key points to remember

  • A passive ETF is a vehicle that seeks to replicate the performance of the broader stock market or a segment thereof by mirroring the holdings of a designated index.
  • They offer lower expense ratios, increased transparency and greater tax efficiency than actively managed funds.
  • However, passive ETFs are subject to full market risk, lack flexibility, and are heavily weighted to the most valuable stocks by market capitalization.

How a passive ETF works

The constituents of a passive ETF track the underlying index or sector and are not at the discretion of a the head of finance. This makes it the opposite of active management— a strategy by which an individual or team makes decisions about the underlying allocation of the portfolio with the aim of beating the market.

Passive ETFs offer investors greater flexibility to execute a buy and keep strategy versus active funds. Advocates of passive investing believe it is difficult to outperform the market, so they aim to match overall performance rather than beat it.

Taking a hands-off approach means the provider can charge investors less without having to worry about the cost of employee salaries, brokerage fees, and research. The strategy also touts the benefits of lower turnover. When assets move in and out of the fund at a slower rate, it leads to lower transaction costs and realized capital gains. Investors can therefore save when it is time to file their tax returns.

Passive ETFs maximize returns by minimizing buying and selling.

Passive ETFs are also more transparent than their actively managed counterparts. Passive ETF providers release funds weights every day, allowing investors to limit strategic drift and identify duplicate investments.

Special Considerations

Passive ETFs have exploded in popularity since they were introduced to the world about a quarter century ago. The bottom Return displayed by actively managed funds and the endorsement of passive investment vehicles by influential figures such as Warren Buffett have led to investors’ cash flowing into passive management, particularly in recent years.

The SPDR S&P 500 (SPY), which was launched in January 1993 to track the S&P 500 Index, is the oldest and best-known ETF.

In September 2019, passive ETFs and mutual fund eventually overtook their active counterparts in assets under management (AUM), according to Morningstar.

Passive ETF vs Active ETF

Most investors don’t just bet on every ETF. They specifically want to pick winners and avoid latecomers. Aspiration of beat the market are common, although evidence indicates that most active fund managers consistently fail to achieve this goal.

Active ETFs seek to meet these needs. These vehicles have many of the same benefits as traditional ETFs, such as price transparency, liquidity, and tax efficiency. Where they differ is that they have a manager installed who can adapt the fund to changing market conditions.

Active vs. Passive investing in ETFs

Although active ETFs trade an index like their passive peers, active managers have some leeway to make changes and deviate from the benchmark when they see fit. Options available to them include modifying sector rotationmarket-timing trades, short saleand buy on margin.

Investors shouldn’t automatically assume that this flexibility guarantees active ETFs to beat the market and their passive peers. Not all calls made will be the right ones, and the tools and employees they employ incur additional costs, leading to increased expense ratios which reduce fund assets and investor returns.

Critique of Passive ETFs

Passive ETFs are subject to total market risk in that when the overall stock market or bond prices fall, the funds that track the index also fall. Another disadvantage is the lack of flexibility. The suppliers of these vehicles cannot modify wallets nor adopt defensive measures, such as reducing holding positions when a sale seems inevitable.

Critics say a hands-off approach can be detrimental, especially during a bear market. An active manager can rotate between sectors to protect investors from downturns. volatility. A passive fund that rarely adjusts to market conditions, on the other hand, is bound to suffer the brunt of a drawdown.

Finally, another notable problem with passive ETFs is that many of the indices they track are capitalization weighted. This means that the greater the market capitalization of a stock, the greater its weight in an investment portfolio. A downside to this approach is that it reduces diversification and leaves ETFs passively weighted toward the big stocks in the market.