A quick and intuitive way of explaining the difference between passive and active ETFs is that passive ETFs aim to own the market, while active ETFs aim to beat the market. 

The question of whether to invest in passive or active ETFs is encountered by most people at some point in their investment journey. Although most investors will be better served by investing in passive ETFs, there are also some arguments to be made in favor of active ETFs. 

In this article, we’ll tackle the topic of active vs. passive ETFs and explain how these two types of investment products stack up against each other.

Passive ETFs

Passive ETFs are investment products that are designed to mirror the performance of an index by holding the assets contained in the index. A passive ETF’s holdings change only to reflect the changes in the underlying index, and aren’t at the discretion of a fund manager.

For example, the the three largest ETFs on the market today all track the S&P 500, an index that contains the 500 largest publicly-traded companies in the United States. The index is weighed by market capitalization. Other popular indices include the Nasdaq-100, the Dow Jones Industrial Average, and the Russell 1000.

Passive ETFs are currently the dominant force in the ETF market. At the time of writing this article, the top 51 ETFs by AUM (assets under management) are all passively managed.

The largest ETFs on the market today are passive ETFs that track indices such as the S&P 500, which captures a large portion of the US equities market, and the Nasdaq-10, which is skewed towards the technology sector.

However, passive ETFs can also have a narrower scope – for example, the iShares Semiconductor ETF (SOXX) ETF tracks an index containing companies in the semiconductor industry, and the Vanguard Health Care ETF tracks an index containing only companies in the health care industry.

There are also ETFs that are even more specific, for example ETFs that invest in the lithium industry, gold ETFs, Bitcoin ETFs, and so forth. 

Active ETFs

In actively-managed ETFs, a portfolio manager has the ability to adjust the fund’s holdings with the goal of beating a benchmark. Of course, this also means that there’s a chance that the fund will underperform the benchmark. 

Active ETFs tend to have significantly higher expense ratios than passive ETFs. The managers overseeing the funds have to be compensated for their work, and the active ETFs can also accumulate substantial transaction costs as they make trades in an attempt to outperform their benchmark.

Conventional active ETFs are required to report their positions daily, but there are now also active ETFs on the market that report their positions less frequently, which arguably preserves more of the potential value offered by active management (because their positions can’t be easily copied).

A semi-transparent ETF is a type of actively-managed ETF that discloses its holdings quarterly instead of daily. Such ETFs have been entering the market since 2019, when securities regulator SEC changed a rule to allow ETFs that aren’t required to disclose their holdings daily. 

Active vs. passive ETF – Which should you pick?

  Pros Cons Passive ETFs

  • Much lower fees than actively-managed ETFs

  • Transparent holdings, which means investors know exactly what they are buying or holding

  • Tend to outperform actively-managed ETFs over the long term

 

  • No potential for overperformance

  • Susceptible to market downturns

Active ETFs

  • Potentially higher returns compared to the benchmark

  • Lower costs than comparable mutual funds

  • Substantially higher costs than passively-managed ETFs

  • Over the long term, active ETFs tend to underperform compared to passive ETFs

Most investors will be better served by passive ETFs. After accounting for fees and expenses, studies suggest that the majority of active managers underperform the market over the long term. By capturing the market’s return at minimal cost, passive funds ETFs tend to outperform most active managers over time.

The bottom line

Both types of ETFs have their own benefits, although we believe that passive ETFs are a better choice for the average investors.

Passive ETFs are great for those who want to match index returns and focus on keeping fees as low as possible. On the other hand, you might want to choose an active ETFs if you want the chance to beat market returns and trust that the ETF is managed by professionals with the expertise to do so.

If you want to learn more on the topic of ETFs, we invite you to take a look at the following articles:

  • What Is a Fixed Income ETF?

  • Best ETF Screeners

  • VTI vs VOO: Which Vanguard ETF is Better?

  • Best Growth ETFs to Buy in 2024

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