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 designated index—a collection of tradable assets deemed 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 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 a fund manager. That makes it the opposite of active 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 a buy-and-hold strategy 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 lower turnover. 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 fund weightings each 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 about a quarter of a century ago. The low returns posted by actively managed funds and the endorsement of passive investing vehicles by influential figures such as Warren Buffett have led investor cash to flood 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 surviving and most widely known ETF.

In September 2019, passive ETFs and mutual funds finally surpassed their active counterparts in assets 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 the laggards. Aspirations of beating the market are common, even though evidence points to most active fund managers regularly failing to achieve this goal.

Active ETFs seek 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.

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Active Vs. Passive ETF Investing

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 changing sector rotation, market-timing trades, short selling, and buying on margin.

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 higher expense ratios that reduce the fund's assets and investors' returns.

Criticism of Passive ETFs

Passive ETFs are subject to total market 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 to portfolios nor 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 a bear market. An active manager can rotate between sectors to shield investors from periods of volatility. 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.