When it comes to investing, investors can generate promising returns with passively managed ETF portfolios. Investors have flocked to passive portfolio management in recent years due to the lower-than-expected returns experienced with actively managed funds, as well as the endorsement of passive investing by notable personalities like Warren Buffett.
While the goal of active portfolio management is to attempt to outperform the market against a certain benchmark, such as the S&P 500 Index, a passive portfolio management strategy is designed to imitate the benchmark as closely as possible in order to attain the same – or similar – results as the chosen index.
Passive ETF portfolios are popular as they provide increased flexibility, greater transparency and tax efficiency, and lower expense ratios than many actively managed portfolios. This article will teach you everything you need to know about a passive ETF portfolio.
- First, what is an ETF?
- How do passive ETF portfolios work?
- Key Features of passive ETF portfolios
- What to watch out for with a passive ETF portfolio
- How to invest in a passive ETF portfolio
First, what is an ETF?
Exchange-Traded Funds (ETFs) are baskets of securities that are traded like stocks on an exchange. They contain many different types of investments, such as stocks, bonds, and commodities, and are normally – though not always – designed to track an index and trade intraday.
This allows investors to purchase and sell all of the securities that constitute an entire market (such as the Nasdaq) with ease, and in one single transaction. As a result, ETFs give you the flexibility to enter or exit a position at any moment during the day.
Because ETFs hold numerous underlying assets rather than just one, they are also a popular investment vehicle for diversification.
The rise of the ETF has been beneficial to investors because it has opened up new low-cost alternatives for virtually every asset class available in the market. However, it can be a challenging task for investors to filter through the thousands of ETFs available globally.
How do passive ETF portfolios work?
Passive index investing with ETFs usually involves holding the same securities, at the same weights, as the underlying index. This could be all of the index’s components or a reasonably representative amount of it. They’re typically weighted by the market capitalization (size) of the companies held. Passive management and formulaic sampling when replicating the index also keeps fees low.
A passive ETF portfolio’s components are determined by the underlying index or sector, rather than by a fund manager. That makes it different to an actively managed portfolio, where an individual or team decides on the underlying portfolio allocation in a bid to outperform the market.
Proponents of passive investing prefer to match the market’s entire performance rather than seek to outperform it. It is well understood that it is difficult to beat the market and thus, investors often experience better overall returns in the long-term by following the passive route.
Key Features of passive ETF portfolios
Passive ETFs provide greater flexibility when it comes to executing a buy-and-hold strategy. As ETFs trade like stocks on an exchange, it makes it possible to buy and sell shares throughout the day, and check current market prices at any time throughout the day.
2. Costs and tax efficiency
Many passive ETFs have low expense ratios when compared to other, actively managed investment solutions. ETFs that track an index also rarely have hefty capital gains tax bills at the end of the year, and the advantage of capital gains being realized only when shares are sold. Furthermore, they experience low fund turnover that results in low transaction costs.
Taking a passive approach also allows ETF providers to charge investors less expensive fees, because things like brokerage fees and employee salary costs are no longer a significant factor.
Passive ETFs are more transparent than actively managed ETFs. They usually publish their fund holdings and weightings on a daily basis, allowing investors to spot any duplicate positions and limit strategy drift.
4. Superior returns in the medium-long term
Passive ETF investing maximizes returns by minimizing buying and selling. The purpose of passive investing is to steadily accumulate wealth. Often referred to as a buy-and-hold approach, passive investing involves purchasing securities with the intention of holding them for the long-term.
Passive investors, unlike active traders, are not looking to profit from short-term price swings or market timing. The passive investment approach is based on the idea that the market will generate positive returns over time.
Owning an index, or a series of indices, is significantly easier to apply and understand than a dynamic approach that necessitates continuous research and adjustment.
What to watch out for with a passive ETF portfolio
As with any investment vehicle or strategy, there is potential risk, and past performance never guarantees future performance. Watch out for these potential drawbacks when it comes to a passive ETF portfolio.
- Overall stock market decline and bear market conditions
Passive ETF portfolios are susceptible to total market risk, meaning that if in the event the overall stock market or bond prices decrease in value, so do the funds that track the index.
Some argue that taking a passive approach might be especially harmful during a bear market (when a market’s price falls over an extended period of time). To protect investors from moments of volatility, an active manager can switch across sectors and better hedge against market turmoil by avoiding “losers”. A passive fund, on the other hand, is forced to bear the brunt of a drop since it rarely reacts to market conditions.
2. Lack of flexibility in choice
While flexibility is also a positive feature of passive ETF portfolios, there is also a lack of flexibility in terms of choice. Providers are unable to make portfolio modifications or take defensive actions, like reducing positions on holdings when a sell-off appears imminent.
3. Exchange related liquidity risks
If the underlying index does not have a limit on security level weights, the index ETF may have a large concentration of top-performing stocks, exposing investors to company-specific risks. Exchange-related liquidity risk is important because, despite the ETF’s modest expenses, an unfavourable bid-ask spread may work against the interests of the investor and have a negative impact at exit.
Another potential issue worth considering is that many of the indices that passive ETF portfolios monitor are capitalization-weighted. In other words, if the stock’s market capitalization is large, the higher its weight will be in an investment portfolio. This has the slight disadvantage of reducing diversification and leaving passive ETFs heavily weighted toward major stocks in the market.
How to invest in a passive ETF portfolio
To invest in a passively managed ETF portfolio, simply select an online broker, select an index (or several) to invest in, such as the S&P 500, and purchase as many shares as you’d like. That’s all there is to it!
You can also enlist the help and expertise of a robo-advisor like arty that designs optimal ETF portfolios for you, which you can then copy to your own brokerage account each month. This is a great way for anyone to increase their chances of superior returns.
With rising inflation and expanding economies, all investors should aim to improve their portfolios in order to outperform inflation and earn competitive returns. Passive investing is a great asset allocation method that investors can use to achieve a diversified portfolio mix, which provides more protection against volatility, as well as achieve greater returns over time with minimal effort.
Notably, the question of whether investors should utilize active or passive methods in their portfolios has been framed in terms of outperformance. In truth, however, both can coexist in a portfolio if an investor uses a hybrid strategy. Ultimately, though, investing in passive ETFs helps limit the risk of actively-managed schemes underperforming.
If you would like to know more about investing in a passive ETF portfolio, talk to the arty team! arty is a robo-advisor that specialises in optimal ETF portfolio allocations. Simply choose one of our five portfolios to get started for free!