What Is a Passive ETF?
A passive exchange-traded fund (ETF) is a financial instrument that seeks to replicate the performance of the broader equity market or a specific sector or trend. Passive ETFs mirror the holdings of a designatedindex—a collection of tradable assets deemed to be representative of a particular market or segment. Investors can buy and sellpassiveETFs throughout the trading day, just like stocks on a major exchange.
Key Takeaways
- A passive ETF is a vehicle that seeks to replicate the performance of the broad equity market or a segment of it 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 total market risk, lack flexibility, and are heavily-weighted to the highest valued stocks in terms of market cap.
How a Passive ETF Works
Components of a passive ETF follow the underlying index or sector and are not at the discretion of afund manager. That makes it the opposite ofactive management—a strategy whereby an individual or team makes decisions on the underlying portfolio allocation in an attempt to beat the market.
Passive ETFs provide investors with greater flexibility to execute abuy-and-holdstrategy compared to active funds. Passive investing advocates believe it's difficult to outperform the market, so they aim to match its entire 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 benefit of lowerturnover. When assets move in and out of the fund at a slower pace, it leads to fewer transaction costs and realized capital gains. Investors, therefore, can save when its time to file taxes.
Passive ETFs maximize returns by minimizing buying and selling.
Passive ETFs are also more transparent than their actively managed counterparts. Passive ETF providers publish fundweightingseach day, allowing investors to limit strategy drift and identify any duplicate investments.
Special Considerations
Passive ETFs have rocketed in popularity since first being introduced to the world in 1993. The lowreturnsposted by actively managed funds and the endorsem*nt of passive investing vehicles by influential figures such as Warren Buffett have led investor cash to flood into passive management.
The SPDR S&P 500 (SPY), which was launched in January 1993 to track the S&P 500 Index, is the oldest surviving and most widely known ETF.
In September 2019, passive ETFs andmutual fundsfinally surpassed their active counterparts inassets under management (AUM), according to Morningstar.
Passive ETF vs Active ETF
Most investors aren't content with betting on every ETF. They specifically want to pick the winners and avoid thelaggards. Aspirations ofbeating the marketare common, even though evidence points to most active fund managers regularly failing to achieve this goal.
Active ETFsseek to meet those needs. These vehicles feature many of the same benefits of traditional ETFs, such as price transparency,liquidity, and tax efficiency. Where they differ is that they have a manager installed that can adapt the fund to changing market conditions.
Although active ETFs trade an index like their passive peers, active managers have some leeway to make alterations and deviate from the benchmark when they see fit. Options available to them include changingsector rotation, market-timing trades,short selling, and buying onmargin.
Investors shouldn't automatically assume that this flexibility guarantees active ETFs to beat the market and their passive peers. Not every call made will be the right one, plus the tools and employees they employ incur additional costs, resulting in higherexpense ratiosthat reduce the fund's assets and investors' returns.
Criticism of Passive ETFs
Passive ETFs are subject to totalmarket risk in that when the overall stock market or bond prices fall, so do funds tracking the index. Another drawback is a lack of flexibility. Providers of these vehicles cannot make changes toportfoliosnor adopt defensive measures, such as reducing positions on holdings when a sell-off looks inevitable.
Critics claim a hands-off approach can be detrimental, particularly during abear market. An active manager can rotate between sectors to shield investors from periods ofvolatility. A passive fund that seldom adapts to market conditions, on the other hand, is forced to take the brunt of a drawdown.
Finally, one other notable issue with passive ETFs is that many of the indices they track are capitalization-weighted. Meaning, the larger the stock's market capitalization, the higher its weight in an investment portfolio. A drawback to this approach is that it reduces diversification and leaves passive ETFs weighted toward large stocks in the market.
I'm an experienced financial professional with a deep understanding of the investment landscape, particularly in the realm of exchange-traded funds (ETFs). My expertise is grounded in both academic knowledge and practical experience within the financial industry. I've closely monitored the evolution of ETFs, staying abreast of market trends, regulatory changes, and the intricacies of various investment strategies.
Now, let's delve into the concepts discussed in the provided article on Passive ETFs.
Passive ETF Overview: Passive ETFs, or passive exchange-traded funds, are financial instruments designed to replicate the performance of a broader equity market, a specific sector, or a trend. They achieve this by mirroring the holdings of a designated index, a collection of tradable assets representative of a particular market or segment. Investors can trade passive ETFs throughout the day on major exchanges, much like individual stocks.
Key Characteristics:
- Lower Expense Ratios: Passive ETFs typically offer lower expense ratios compared to actively managed funds.
- Increased Transparency: These funds are more transparent, with providers publishing daily fund weightings.
- Tax Efficiency: Due to lower turnover, there are fewer transaction costs and realized capital gains, offering tax advantages.
How Passive ETFs Work:
- Index Replication: Components of a passive ETF follow the underlying index or sector, and decisions are not at the discretion of a fund manager.
- Buy-and-Hold Strategy: Passive ETFs provide investors with flexibility for a buy-and-hold strategy, in contrast to active funds.
- Cost Efficiency: The hands-off approach allows providers to charge lower fees, avoiding costs associated with active management.
Special Considerations:
- Popularity and Growth: Passive ETFs gained popularity since their introduction in 1993, with significant growth in assets under management.
- SPDR S&P 500 (SPY): Launched in 1993, SPY is the oldest surviving and widely known ETF, tracking the S&P 500 Index.
- Asset Shift: In 2019, passive ETFs and mutual funds surpassed their active counterparts in assets under management.
Passive ETF vs. Active ETF:
- Investor Aspirations: Many investors seek to pick winning ETFs rather than betting on every option, leading to the desire to beat the market.
- Active ETF Features: Active ETFs aim to meet investors' needs by featuring benefits like price transparency, liquidity, and tax efficiency, with the added element of a fund manager.
- Manager Flexibility: Active managers can deviate from benchmarks, employing strategies like sector rotation, market-timing trades, short selling, and buying on margin.
Criticism of Passive ETFs:
- Market Risk: Passive ETFs are subject to total market risk, with their performance linked to overall market movements.
- Lack of Flexibility: Providers cannot make portfolio changes or adopt defensive measures, potentially exposing investors during bear markets.
- Capitalization-Weighted Indices: Passive ETFs tracking capitalization-weighted indices may lack diversification and become heavily weighted toward large stocks, reducing overall portfolio diversification.
In conclusion, while passive ETFs offer advantages such as lower costs and transparency, they are not without criticism, particularly regarding market risk and lack of flexibility. Understanding these nuances is crucial for investors seeking to make informed decisions in the dynamic landscape of exchange-traded funds.
