Passive ETFs
An exchange-traded fund (ETF) is technically structured as an open-end management company, but it’s not a mutual fund. That may sound confusing, but ETFs are unique. While they are structured and operate as an open-end management company, they are not transacted like mutual funds. As their name suggests, ETFs trade on exchanges in the secondary market and are negotiable securities.
ETFs share similar characteristics with both open-end and closed-end funds. They purchase and hold securities in a large portfolio on behalf of their investors. ETFs maintain daily-calculated net asset values (NAVs) that reflect the current value of fund assets. Due to the large number of securities held in most ETF portfolios, instant diversification is obtained when purchasing just one or a few shares. This is similar to index funds, which are mutual funds that are built to track specific indexes.
ETF market prices typically follow their NAVs very closely, even though the shares trade in the secondary market*. Additionally, this security can be bought on margin (with borrowed money), sold short and commissions are involved in their transactions.
*ETF market prices typically match their NAVs due to a feature known as ETF arbitrage. Behind the scenes, institutional investors perform transactions with ETF issuers to manipulate the market price back to NAV if it deviates. This fairly complex process is unlikely to be encountered on the exam.
ETFs are known for tracking indexes. For example, the most popular ETF is the S&P 500 “Spyder” ETF. Investors in this ETF make money when the S&P 500 rises, and lose when it falls. This is passive management, which avoids investing in only a limited number of stocks, bonds, or other securities within a market. Remember, indexes track large market segments. By investing in a passively managed ETF, investors bet on the “market average.”
Research and data support this approach to investing. For example, the Wall Street Journal ran an experiment for many years that involved blindfolding its writers and having them throw darts at lists of stocks. A portfolio was constructed with all the stocks the darts landed on. Surprisingly, some of these portfolios performed better than professionally managed funds. A quote from the linked article above:
Over 100 six-month contests, the pros have racked up an average gain of 10.9%, compared with 4.5% for the dart throwers and 6.8% for the Dow industrials. The pros have come out ahead of both the darts and the Dow industrials 44 times.
While the professionals averaged higher than the Dow Jones Industrial Average* and the dart throwers, they only edged out both 44% of the time. Given professional (active) management involves added costs and fees, the results certainly make a case for passive management.
*The Dow Jones Industrial Average is a well-known index tracking 30 of the largest US-based stocks.
Active management is the exact opposite approach, which involves picking the best investments available (instead of “taking the average”). Active money managers (like the professionals mentioned above in the dart-throwing article) usually measure their performance against an applicable index. For example, an investor engaging in active management in large-cap stocks would likely compare their performance to the S&P 500. If their investments outperformed the S&P 500, they “beat the market.” Active management strategies seek to consistently beat their comparable index, which is very difficult to do every year. According to this CNBC article:
Just 26% of all actively managed funds beat the returns of their index-fund rivals over the decade through December 2021
If an investor believes throwing darts at a wall produces similar results as spending time and money on research, they should passively invest. ETFs provide an easy way to do this. Today, thousands of ETFs are available that track all different types of indexes. These three ETFs are the most likely to be referenced on the exam:
The names of these ETFs are a word play on the indexes they follow.
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