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It Turns Out Passive ETFs Aren't So Passive After All

Passive ETFs could soon overtake mutual funds in total assets under management, according to the Financial Times. While often pitched as a low-cost way to build a diversified long-term portfolio, new research suggests that most ETFs are active investments in form or function.

The research, published in July 2021 by researchers at Cornell University, the University of Technology Sydney, and the Stockholm School of Economics in Riga, takes a unique look at how many traders and investors use passive ETFs in their active strategies.

In this article, we’ll examine these findings and what they mean for the wider ETF industry and investors.

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Active-in-Form vs. Active-in-Function

The researchers defined active-in-form ETFs as those with portfolios that depart from a chosen benchmark. For example, smart beta ETFs adjust holdings to capture factor exposures and leveraged ETFs adjust holdings to keep leverage constant. As a result, they deviate from an underlying ‘passive’ index providing broad exposure.

Active-in-function ETFs choose a benchmark that embraces or departs from the market. For example, thematic ETFs provide exposure to a designer index, such as tech companies operating in specific niches or country ETFs that provide exposure to just one country. Like active-in-form ETFs, these funds don’t provide ‘broad’ exposure.

The researchers found that active-in-form ETFs showed positive flow-performance sensitivity, charged the highest fees among ETFs, and had the highest within-portfolio turnover. On the other hand, active-in-function ETFs had more concentrated holdings with less with-portfolio turnover but higher turnover in the secondary markets.

Price Discovery & Fee Implications

Passive ETFs have recently come under fire for their impact on market efficiency. Since they invest indiscriminately in broad indexes, critics argue they’re free-riding on the price discovery of active mutual funds. Even worse, they could undermine the market’s efficiency and lead to the mispricing of assets—creating significant long-term risk.

The new research found that active-in-form and active-in-function ETFs account for about 58% of the ETF market by assets, 93% by number, and 78% by dollar volume traded on the secondary market. As a result, passive ETF investors aren’t necessarily indiscriminately investing in the broad market—they’re taking a much more active approach.

At the same time, the researchers found that active ETFs are gaining market share over their less active counterparts, leading to competitive fee pressure, both within the ETF space and across the investment management industry. Therefore, investors could see better returns due to a lesser impact of fees along with more options for their portfolios.

The Bottom Line

New research suggests that the ETF market is more active than it seems with many ‘passive’ funds being active in form or function. The rise in these ETFs results in lower fees and more options for investors while alleviating concerns that passive ETFs are undermining market efficiency.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.