Exchange Traded Fund: Difference Between Active and Passive ETF Investing

passive etf investing
ETFs or Exchange Traded Funds are funds holding assets such as stocks, commodities, bonds, and trading in stock exchanges. These instruments, despite being around for more than 30 years, became popular within the past decade.

ETFs can be a valuable component of any investor’s portfolio, providing a benefit of diversification, giving an opportunity to construct a well-diversified portfolio with just a few ETFs.

Buying shares of ETF mean you are buying shares of a portfolio that track the yield and return of its corresponding index.

These funds only try to replicate the performance of the index, in contrast to other types of funds that aim to outperform the benchmark. ETF provides flexibility to trade hundreds of securities with a single trade.

ETFs are traded like stocks but have characteristic of mutual funds. They can be bought or sold many times during a single trading day, unlike mutual funds, which can be traded only once a day.

These funds are indexed like the Nasdaq-100, S&P 500, and are available in many variances, tracking nearly every index in the market. Those funds can also be structured to track a popular manager’s top picks or duplicate a certain mutual fund, etc.

Having features of a stock also means that ETFs can be bought on margin, sold short, etc. Yet because the fund’s value is determined by the underlying index, ETFs enjoy the additional benefits of broader diversification than shares in single companies.

Investors view ETFs as attractive investment tools because of their low costs, tax efficiency, and stock-like features.

Active and Passive ETF Investing Strategies

Because ETFs purpose is to track an index, they are considered passive ETF investing strategies, unlike mutual funds that are most actively managed. However, the majority of actively managed mutual funds fail to beat their benchmarks.

According to MorningStar, the majority of active managers underperformed their corresponding indexes in seven out of nine categories of mutual funds in 2015.

ETFs provide an effective and low-cost way to implement indexing or passive management.

Passive ETF investing requires little decision-making by the manager, and require lower operating costs.While passive ETF investing is a popular strategy among ETF investors, not all of them are passively managed.

Despite the “not so attractive” track record, many investors aren’t happy with so-called average returns.

Traditionally, fund investors want to go active in less-efficient areas, such as within small-cap stocks or emerging markets. However, active managers have failed to outperform in the small-cap space over the past decade. And several other studies suggest individual investors are better off with index funds.

Even though the investors know that a minority of actively-managed funds beat the market, they’re willing to try anyhow.

Active managers believe their superior skills can exploit anomalies and irregularities in the inefficient markets. However, active investing is more costly, resulting in higher fees and operating expenses.

While actively-managed ETFs run by professional money managers are still not so popular compared to passive strategies, the innovative money management firms try to overcome the challenges of making this product available worldwide.

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