Though not all exchange-traded funds (ETFs) are passively managed, the vast majority are managed this way because most ETFs are indexed funds, meaning they invest in the same stocks as a given index with the goal of matching its returns. The following is a brief explanation of how indexed ETFs work, followed by the four primary reasons most ETFs are passively managed.

Indexed Funds and Passive Management

All index funds are passively managed by nature, because an active management style means the fund executes trades outside of what the index is doing. When a stock begins to lose value, an active manager may decide to sell off the fund's holding to reduce the risk of loss. The manager of an indexed fund cannot sell the stock unless the index deletes it from its roster. All trading activity executed by an indexed fund is triggered by a change in the index it tracks. While the investment industry is typically split on which investment strategy is better, there are a number of reasons why most ETFs remain passively managed.

Low Asset Turnover

One of the primary reasons ETFs are passively managed is because this management style requires very little trading activity, resulting in low asset turnover. When a fund buys or sells a stock, it requires man hours and paperwork to make it happen. This increases the fund's costs, which are then distributed to shareholders. The fact that ETFs are traded on the secondary market just like stocks and bonds also helps reduce asset turnover by making it less likely the funds will need to sell assets to cover a shareholder redemption.

Actively Managed Funds Often Fail to Deliver

Another reason passively managed ETFs remain so popular is that, despite the skill of many fund managers, actively managed funds often fail to deliver the returns they promise. Actively managed funds have much higher expense ratios because of the increased work required of the fund's manager. Even when a fund manages to beat the market in a given year, expenses often eat up a substantial portion of its returns, leaving little net profit for shareholders.

Conversely, passively managed funds are designed to match the returns of an index, for better or for worse. While the opportunities for massive gains are fewer than with active funds, the expenses are greatly reduced as well. Whatever the returns of the fund are for the year, expenses are unlikely to endanger shareholder profit.

Cost and Tax-Efficiency

Passively managed ETFs typically have lower expense ratios than their actively managed counterparts as a result of the reduced workload and decreased trading activity. Because of the market-based trading of ETFs and their ability to create and redeem shares in-kind, passively managed ETFs do not need to rebalance their portfolios frequently. This makes them less likely to make capital gains distributions, which increases the taxable income for their shareholders. While ETFs, in general, are less prone to frequent distributions than mutual funds, passively managed funds are unlikely to make any at all. This means fewer taxable events for shareholders, making these investment products popular among investors looking to limit tax liability. The reduced number of distributions further lowers the expense ratio of passively managed ETFs due to the additional reduction of paperwork and manager interaction.

Pick the Index, Not the Manager

One of the reasons so many investors flock to passively managed ETFs is that, unlike active ETFs or mutual funds, the key criteria is the index, not the manager. When selecting an actively managed investment, it is important to review the manager's track record to ensure she has a history of generating significant returns that cannot be chalked up to luck. When selecting an indexed ETF, the most important factor is your outlook, or that of trained professionals, for the index itself. Selecting a passively managed ETF is primarily a matter of finding an index you are bullish on and locating a fund that tracks that index and is offered by an institution you trust.

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