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Index or Passive: Understanding key differences that impact your portfolio.

Index or Passive: Understanding key differences that impact your portfolio.

July 1, 2019

Index and passive. For the last 40+ years, these two terms have been interchangeable.

But recent developments in the ETF universe – specifically, the growth in “smart beta” funds — highlights a distinction between these two terms which has important implications for investors’ portfolios. For example, investors who think they are buying a passive product may not in practice desire the additional risk profile of certain indexed products.

The Past: Index and Passive

When the first index funds were set up in the 1970s, they were both index and passive. The funds’ portfolios mirrored the constituents of a well-known index designed to measure the performance of a broad segment of the market. For example, the first index mutual fund, aptly named the Vanguard First Index Investment Fund (now the Vanguard 500 Index Fund), based its investments on the S&P 500 Index.

As a result, these early index funds were truly passive investments, because they allowed investors to earn market returns without having to select specific securities.

The equivalence of index and passive largely continued for the next four decades. The growth in index funds was driven by flows into funds based on major market indexes. The S&P 500 continued to be the most popular benchmark index used, but funds based on small-cap stock, international stock and bond indexes were also introduced.

The Present: Index or Passive

However, the increasing popularity of “smart beta” and sector ETF strategies over the past few years means that there’s a growing number of index funds that clearly aren’t passive. These strategies are among the hottest segments of the ETF market today, attracting over $100 billion in assets in 2018 and accounting for over 1 in 5 dollars invested in ETFs.

Yes, smart beta and sector ETFs are invested to mimic the weightings in an index – but these indexes aren’t merely trying to reflect broad market movements. Instead, they are seeking to provide better performance by using active management judgment within the index construction.

Smart beta uses an alternative weighting scheme or quantitative security selection techniques to create an index that is designed to outperform the broad market.. These ETFs are often referred to as “factor funds,” because they are designed to provide exposure to certain securities with certain characteristics, such as stocks with low price-earnings ratios or strong earnings momentum. These characteristics are expected to lead to stronger performance, which is why they are often a core component of active investment management.

Sector ETFs s provide the opportunity to invest in specific sectors or industries. Fund sponsors may create these ETFs only for sectors that they believe have hot prospects, and investors often purchase in the hope of achieving superior performance. Therefore, sector ETFs are most likely to be used as part an active approach to asset allocation.

Drawing the Distinction

Perhaps not surprisingly, the industry’s language hasn’t kept pace with the changing trends. Some database providers and commentators are still using the term “passive” to refer to both traditional broad-market index funds and to ETFs with an active management component.

Others, however, have shifted to the term “index” when talking about categories that include both types of funds – more accurately portraying the complexity of today’s investment landscape.

That’s because there’s no longer a clear dividing line between active and passive. Instead, there’s a full spectrum of investment alternatives – with each point from passive to active playing an important role. Investors need to understand where their investment selections sit on that spectrum to accurately evaluate the risk in their portfolios.

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