ETF 107: Passive vs. Active ETFs Explained

Explore more in our ETF education series:

ETF 101: Understanding the Basics
ETF 102: The Inner Workings of ETF Creations and Redemptions
ETF 103: Is This ETF Right for You?
ETF 104: Getting the Most Out of Your ETF Trades
ETF 105: Gaining Efficient Access to Bond Markets
ETF 106: Debunking Fixed Income Myths
ETF 107: Passive vs. Active ETFs Explained

Investment Vehicles vs. Investment Styles

Investment products can be categorized by investment vehicle and investment style. Here we’ll review the key similarities and differences between two types of investment vehicles (ETFs vs. mutual funds) and investment styles (active vs. passive). We will also highlight portfolio considerations for the different types of investments: passive ETFs, active ETFs, passive mutual funds and active mutual funds.

Understand the Main Attributes of ETFs vs. Mutual Funds

Though both are a diversified collection of assets, the primary difference between ETFs and mutual funds is that ETFs trade on an exchange. Revisit ETF 101: Understanding the Basics to learn more, but here is a quick recap.

1. Transparency: With the exception of a much smaller group of new ETFs called non-transparent ETFs, most ETFs are required to publish their holdings at the end of each trading day, whereas a mutual fund has a quarterly reporting requirement. ETF prices also update in real time during the trading day, whereas a mutual fund price updates once per day, at market close.

2. Cost: ETFs have historically been less expensive for investors due to a simpler fund administration process and less overhead needs compared to an equivalent mutual fund with similar exposure. Also sales fees, such as loads and trailer fees, are non-existent in the ETF universe.

3. Tax Efficiency: While both vehicles are open-ended investment structures, the ETF structure makes use of a mechanism called in-kind creations and redemptions (see ETF 102: The Inner Workings of ETF Creations and Redemptions). This helps the ETF manager minimize taxable events throughout the year. The same process is not available with a mutual fund structure.

4. Tradability: An ETF can be traded throughout the day, which means it can be both purchased and sold on an intraday basis, just like a stock.

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ETF 107: Passive vs. Active ETFs Explained

Active vs. Passive Investing Explained

Actively managed funds, whether mutual fund or ETF, are similar in that there is typically a portfolio manager making decisions regarding model changes, choice of holdings, and transactions within the fund. Both vehicles also seek to provide additional performance (or alpha) over their respective benchmarks.

The main differences between actively managed mutual funds and actively managed ETFs reflect the differences outlined above between mutual funds and ETFs: transparency, cost, tax efficiency and tradability. For example, a transparent actively managed ETF still reports its holdings on a daily basis, while a similar mutual fund reports holdings quarterly.

Passively managed mutual funds and passively managed ETFs are both designed to track a specific index’s performance. Instead of attempting to add performance over a benchmark index, they simply intend to match its underlying index’s performance. There are hundreds of different indices that exist along with many different index providers that can offer investors broad or targeted exposures.

The differences between passively managed mutual funds and ETFs are once again due to the structure of the two investment vehicles. For example, even though an ETF tracking the S&P 500 and a mutual fund tracking the S&P 500 have similar objectives, the tradability of the ETF is much greater.

Portfolio Considerations for Active and Passive ETFs and Mutual Funds

The table below recaps some of the key features of each of the four different types of investments covered.