Passive ETF: What It Is and How It Works

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.

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 assets 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 worrying 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 it's time to file taxes.

Passive ETFs are also more transparent than their actively managed counterparts. Passive ETF providers publish fund weightings daily, allowing investors to limit strategy drift and identify duplicate investments. 

Special Considerations

Passive ETFs have rocketed in popularity since first being introduced to the world in 1993. 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.

In August 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 who can adapt the fund to changing market conditions.

Although active ETFs generally mirror 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 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 because 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 or 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. Conversely, a passive fund that seldom adapts to market conditions is forced to take the brunt of a drawdown.

Finally, another notable issue with passive ETFs is that many of the indices they track are capitalization-weighted. This means 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.

The Bottom Line

Passive ETFs are funds that purchase shares listed on benchmark indexes. They are popular among investors because they offer exposure to entire sectors or segments that many smaller investors could not fully access or mimic on their own due to costs.

The funds have several advantages, but they also have disadvantages. However, over the long term, passively managed ETFs tend to outperform actively managed funds, so investors with long-term outlooks can benefit from the lower costs and diversity these funds offer.