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DEFINITION of 'Passive ETF'

Passive ETFs are a vehicle to track an entire index or sector with a single security. Investors can buy and sell funds throughout the trading day, just like stocks on a major exchange. This provides them with greater flexibility to execute a buy and hold strategy without the aide of an actively managed fund. Using a passive approach has additional benefits of lower expense ratios, increased transparency and greater tax efficiency. For these reasons, investors have moved large blocks of assets from active funds into passive ETFs in recent years. State Street's $230 billion SPDR S&P 500 ETF is the most widely held passive fund, listed under the ticker symbol SPY

BREAKING DOWN 'Passive ETF'

Passive ETFs represent a large portion of fund flows over the past two decades. In July 2017, US ETFs topped $3 trillion in assets under management between passive, active and other types of strategies. Some key features of the passive industry have helped support the recent surge of deposits; costs, flexibility and transparency. Components of a passive ETF is determined by the underlying index or sector instead of the discretion of a fund manager. 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. By doing so, investors can save when it comes time to file their taxes. Meanwhile, passive ETFs are more transparent than an actively managed investment. Providers publish fund weightings each day, giving investors an opportunity to limit strategy drift and identify any duplicate investments. 

Passive ETFs operate like unit investment trusts (UITs) in that they reset at regular intervals. The fund provider also doesn't generate internal capital gains like actively-managed funds. However, they differ from UITs in that they can be bought and sold throughout a normal trading day. 

Risks of 'Passive ETFs'

Critics of passive investing claim the hands-off approach can't withstand the pressure of a down market. An active manager can rotate between sectors to shield investors from periods of volatility, but a passive fund that seldom adapts to market conditions may take the brunt of a drawdown. That said, the recent bull market has failed to bring about conditions where an active fund could outperform a passive strategy. 

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