Passive Investing: ETFs vs. Index Funds

Key Takeaways

  • The passive strategy of “set it and forget it” may seem easy, but it can be tempting to intervene when your account value is tanking.
  • There are some key differences between exchange traded funds and index funds.
  • Some portfolio managers and retail investors use index fund or exchange traded funds (ETFs) actively, which is far from true passive investing.

The idea of passive investing can appeal to investors for several reasons:

  • Passive investing can allow your portfolio to track a market index or the broader market.
  • Your returns may outperform those of other investors who make emotional trades or try to time the market.
  • You could achieve all of this without having to do much—just set and forget your portfolio—to build your wealth.

For investors who consider a passive approach, two of the most popular investment vehicles are exchange traded funds (ETFs) and index funds. Many investors think the two categories are one and the same, but they aren’t.

Each instrument presents its own set of potential advantages and both could potentially be used in a passive investment strategy. In this article, we will look at their key differences and discuss passive investing itself—how a relatively smart, simple, and easy-to-follow strategy, in theory, can be difficult to follow in practice.

What are the differences between ETFs, mutual funds and index funds? Let’s begin by explaining ETFs.

What Are ETFs?

Over the last decade, exchange-traded funds (ETFs) have exploded in popularity. Like a mutual fund, an ETF is made up of a “basket” of assets. Yet ETFs actually trade more like stocks. They can be bought and sold from a brokerage account throughout the trading day on a stock exchange.

On the other hand, mutual funds usually trade only at the end of a trading day when their net asset value is assessed. The intraday tradability of an ETF makes them more flexible and allows investors to be more responsive to the market throughout the trading day—potentially a good thing but one that can lead to more investing mistakes.

In addition to this flexibility, ETF investors can take advantage of different investment strategies. ETFs can be used to diversify across a wide range of different sectors, countries and asset classes. In some accounts, they can be sold “short” if an investor wants to profit from an ETF’s decline, and they can be bought on borrowed margin in some investment accounts—these are observations not recommendations. Mutual funds, on the other hand, may not be as flexible.

Another appealing aspect of ETFs is their lower cost compared to some mutual funds. Different ETFs come with their own expense ratio charges, but they are often cheaper than mutual funds. If you purchase low-cost ETFs, they may allow you to diversify your portfolio at a lower cost.

With a clear picture of the differences between ETFs and mutual funds, let us consider how ETFs compare with index funds in more detail.

ETFs vs. Index Funds

We will start with the definition of an index fund. An index fund is a form of mutual fund or ETF that tracks a specific index. It is a general term that applies to both types of funds, as long as they are designed to mimic a given index, grouping or classification.

For example, some index funds track primary stock indexes like the S&P 500, MSCI World or Nasdaq 100. Other funds are designed more narrowly to track sectors of the broader market (e.g., technology, energy or real estate). There are also funds that track the wider economic output of various countries.

Buying into index mutual funds are usually fairly low cost but index fund ETFs may be more efficient and affordable. Perhaps because of their efficiency and affordability, index ETFs have become popular among folks who consider themselves passive investors. The underlying assumption behind passive investing is that most people can’t beat the broader market. And if you can’t beat the broader market, then you can at least join the broader market by buying into a low-cost ETF that tracks an index like the MSCI World Index.

Given the ease and flexibility of index ETFs, do investors really take a passive approach to these instruments? We believe true passive investing is more of a myth. Index ETFs are actually traded quite actively by many active portfolio managers and retail investors—some who even claim to be passive investors.

Index ETFs and Passive Investing

Index funds are low cost, easily tradable and extremely popular. While the common assumption is that most people buy index ETFs in passive strategies (to set and forget), that may be far from the truth. In some actively managed funds, professional managers may trade index ETFs. While they may be using so-called passive products, these managers can also use index funds for their active portfolio management.

But portfolio managers aren’t the only ones using passive index ETFs actively. Many retail investors who aim to implement a passive investment strategy also end up actively managing their own portfolio using passive instruments.

Many People Struggle to Truly Invest Passively

Passive investing is about holding on to an investment and avoiding active trading decisions. Commonly, “passive” investors try to find investments that mimic market indexes, and their goal is generally to buy and hold for the longer term. It sounds easy, but many investors who hold passive index funds often risk making emotional decisions when market volatility hits.

When you see the market drop big in a short time frame, it can be incredibly difficult to just set and forget your investments. Instead, some passive investors end up trying to time the market, buying ETFs only to bail when they see the market decline. In short, they end up actively buying high, not holding their investments long enough and selling at the wrong times, contrary to their intended passive strategy.

In addition, many ETFs are actively traded like individual stocks. So while you may think you’re investing passively by holding an ETF or two, you may not be passively investing if those fund managers are implementing active trading strategies.

How Fisher Investments Can Help

A passive strategy may seem easy to follow, but the temptation to intervene when your fund’s value drops can be powerful. If your aim is to invest for the long term, it might be beneficial to work with an adviser who can help you stay disciplined and reassured during all market conditions.

Our professionals may be able to evaluate your portfolio and discuss your current ETF or index fund holdings. Contact us today!

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