What it means
An exchange-traded fund, or ETF, is a basket of investments that can be bought and sold on a stock exchange throughout the day, like a single share. A passive ETF keeps its basket in line with a chosen index.
If the index holds 500 companies, the fund holds those same 500 in similar weights. The appeal is cost and simplicity.
There are no stock pickers to pay, and trading happens only when the index changes or when investors add or remove money. The annual fee, called the expense ratio, is often a small fraction of a per cent of the money invested.
Fees matter because they compound. A difference of 0.90 percentage points a year may look small, but over decades it can take a large slice of the final balance.
This is the main argument made by supporters of passive investing. The fund will not match the index exactly.
The gap between the fund's return and the index's return is called tracking difference, and it is mostly explained by fees and the costs of trading. A good passive ETF keeps this gap small.
There are limits to what passive means. The fund cannot avoid falling markets, and it holds whatever the index holds, including overpriced companies.
Some indexes are also narrow or unusual, so an ETF can be passive in method but still be risky in practice. For businesses, passive ETFs are one way to invest surplus cash or pension money cheaply and transparently.
Treasurers should still check the index, the fees, the size of the fund and how easily it can be sold.
In practice
Real-world examples.
Example
A small business owner invests spare cash in a passive ETF tracking a broad stock index. She pays a low annual fee and does not need to choose individual shares. She checks the fund once a year and adds money as her cash allows. The low fee means more of her money stays invested over the years.
Example
A pension scheme adds a passive bond ETF to its portfolio to get exposure to government bonds without buying each one. The ETF is easy to buy and sell and provides daily prices. The trustees monitor the tracking difference each quarter. Because the fund holds many bonds, a default by one issuer would have only a small effect.
Example
A financial adviser recommends a passive ETF for a client's long-term savings. She explains that the client will earn roughly the market return less the small fee. The client avoids the risk of choosing the wrong fund manager. She also reminds the client that the value will fall when the market falls.
Formula
Calculation
Annual fee cost = amount invested x expense ratio
An investor puts $100,000 into a passive ETF with an expense ratio of 0.10% and another $100,000 into an actively managed fund charging 1.00%. The passive ETF costs 100,000 x 0.0010 = $100 a year. The active fund costs 100,000 x 0.0100 = $1,000 a year. The difference is 1,000 - 100 = $900 a year, which is 0.90% of the amount invested, before considering any difference in performance.Case study
Seen in the real world.
Redstone Logistics is an illustrative, fictional company that invested $2,000,000 of surplus cash for several years. Its treasurer initially chose an actively managed fund charging 0.95% a year, hoping to beat the market.
After three years the fund had returned slightly less than its benchmark index, and the fees had cost about $57,000. The treasurer switched to a passive ETF charging 0.08%, which brought the annual fee down to $1,600.
In the illustrative outcome, the company earned close to the index return and saved about $17,400 a year in fees. The lesson was that low cost does not guarantee the best return, but it removes a certain drag. The treasurer also began to report tracking difference to the board each year, so that any drift from the index would be noticed quickly.
Watch out
Common mistakes.
- Believing a passive ETF is risk free, when it falls with the market it tracks.
- Comparing funds by name alone, when the underlying index, fees and tracking difference can differ greatly.
- Ignoring trading costs, such as the gap between buying and selling prices, which can matter for small or thinly traded funds.
Questions
People also ask.
What does passive mean in this context?
It means the fund follows a set index and does not try to pick winners, so there is little buying and selling by a manager. Many investors like this approach because the result is easy to understand and compare.
Is a passive ETF the same as an index fund?
They are close cousins, since both track an index, but an ETF trades on an exchange during the day while a traditional index fund is bought at a daily price from the provider. Both can be a sensible core holding, depending on the investor's preferences about trading and fees.
Do passive ETFs always beat active funds?
No, but because of their lower fees many active funds struggle to beat them over long periods. The gap in fees is one of the few advantages that can be known in advance.
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