Active vs Passive ETFs

The Purpose of the Distinction

ETFs, like mutual funds, are pooled investment products that offer investors the opportunity to purchase shares of a fund that holds the assets it tracks.

As of October 2026, historically, most ETFs tracked indexes rather than being actively managed, and most of the largest ETFs today continue to track major indexes. However, many newer ETFs are actively managed. The Securities and Exchange Commission (SEC) did not approve the first actively managed ETF until nearly fifteen years after index-based ETFs were introduced.

The combined securities and other assets the ETF owns are known as its investment portfolio, which is usually managed by an SEC-registered investment adviser. Investment objectives and strategies, which are detailed in prospectuses and related documents, can vary from one ETP to another. ETPs track the performance of underlying assets or benchmarks.

While passive investors generally seek to match market returns, active investors (or managers) aim to exceed market performance. While active investors have the potential opportunity to generate excess returns, passive investors must generally strive for market performance. Given that these strategies are opposites, the advantages of one tend to be disadvantages for the other.

The performance of an actively managed fund is heavily dependent on the skill of the manager, along with other economic factors.

Passive ETFs and Index Funds

A passive fund is a mutual fund, exchange-traded fund (ETF), or unit investment trust (UIT) that follows an investment strategy designed to achieve approximately the same return as a particular index before fees. Passively managed mutual funds, ETFs, and UITs are also called index funds.

An index fund will attempt to achieve its investment objective primarily by investing in the securities (stocks or bonds) of companies that are included in the selected index. For an index-based ETF, the adviser seeks to track an underlying securities index and achieve returns that closely correspond to the returns of that index.

A market index measures the performance of a “basket” of securities (like stocks or bonds), which is meant to represent a sector of a stock market, or of an economy. Traditional indexes are generally designed with rules governing investment selection that seek to match the performance of a specific market.

Indexes can be broad-based (such as the S&P 500) or narrow (such as an index focused on gold miner stocks). Other ETPs track indexes that are more narrowly focused, such as those made up of companies in a specific industry sector or country, corporate bonds with particular credit ratings, or individual commodities or currencies. ETPs can track a wide variety of indexes across many asset classes, as well as different investment or trading strategies.

The vast majority of ETPs are designed to track the performance of a particular market index or benchmark and are similar to index mutual funds. Index funds have generally followed a passive, rather than active, style of investing. This means they aim to maximize returns over the long run by not buying and selling securities very often.

How Index-Based ETFs Track an Index

A passive strategy seeks to achieve approximately the same return as a particular index. The strategy can be implemented by purchasing all of the securities in the index or a representative sampling. Index funds may take different approaches to track a market index: some invest in all of the securities included in a market index, while others invest in only a sample of the securities included in a market index.

Some index funds may also use derivatives (like options or futures) to help achieve their investment objective or invest in a representative sample of the companies included in an index.

Market indexes often use a company’s market capitalization to decide how much weight that security will have in the index. Market capitalization (or “market cap”) is a measure of the total value of the company’s shares. The total value is equal to the share price times the number of shares outstanding.

In a market-cap-weighted index, securities with a higher market capitalization value account for a greater share of the overall value of the index. Some market indexes, such as the Dow Jones Industrial Average, are “price-weighted.” In this case, the price per share will determine the weight of a security.

Most ETPs are designed to track the performance of an underlying index; however, sometimes their performance may diverge. Tracking error occurs when the returns of the ETP deviate from the returns of its underlying benchmark, which can impact investor performance (either negatively or positively).

Tracking Error. An index fund may not perfectly track its index. Underperformance. An index fund may underperform its index because of fees and expenses, trading costs, and tracking error.

Lack of Flexibility. An index fund may have less flexibility than a non-index fund to react to price declines in the securities in the index.

Actively Managed ETFs

An active, or actively managed, mutual fund or exchange-traded fund (ETF) follows an investment strategy that relies on the skill of an investment adviser to construct and manage its portfolio in an effort to provide exposure to certain types of investments or outperform an investment benchmark or index.

This means that an adviser of an actively managed fund may buy or sell investments in the portfolio without regard to conformity with an index. But the investments must be consistent with the overall investment objective and strategies of the fund.

For an actively managed ETF, the adviser buys or sells components in the portfolio without regard to conformity with an index. Actively managed funds are not based on an index.

In contrast, an actively managed fund often seeks to outperform a market (usually measured by some kind of index) by doing more frequent purchases and sales. Active investors might shift their portfolio in response to current or prospective future market conditions.

Active investors can alter their portfolio composition frequently, if necessary, to try to meet changing conditions or evolving needs. An actively managed fund has the potential to outperform the market or its chosen benchmark, but its performance is heavily dependent on the skill of the manager.

What Index-Based and Actively Managed ETFs Share

Under Rule 6c-11(a)(1), exchange-traded fund means a registered open-end management company that issues (and redeems) creation units to (and from) authorized participants in exchange for a basket and a cash balancing amount if any, and whose shares are listed on a national securities exchange and traded at market-determined prices.

Under Rule 6c-11(a)(1), basket means the securities, assets or other positions in exchange for which an exchange-traded fund issues (or in return for which it redeems) creation units. Under Rule 6c-11(a)(1), creation unit means a specified number of exchange-traded fund shares that the exchange-traded fund will issue to (or redeem from) an authorized participant in exchange for the deposit (or delivery) of a basket and a cash balancing amount if any.

Index-based and actively managed ETFs that comply with the rule’s conditions function similarly with respect to operational matters, despite different investment objectives or strategies.

Unlike mutual funds, ETFs are listed on an exchange, can be traded throughout the day, and generally don’t sell shares to, or redeem shares from, retail investors directly. Instead, ETFs, and ETPs more generally, employ a unique share issuance and redemption mechanism.

An ETF enters into contracts with financial institutions (typically large broker-dealers) to act as “authorized participants” (APs). APs purchase and redeem shares directly with the ETF in the primary market in large blocks of shares called creation units. APs typically sell some or all of their ETF shares in the secondary market, on an exchange. This enables investors to buy and sell ETF shares like the shares of any publicly traded company.

The assets held by an ETF might pay interest or dividends, which may be either reinvested or paid periodically to shareholders, depending on the way the ETF is structured.

Portfolio Transparency

Most ETFs post their portfolio holdings on their websites daily. Under Rule 6c-11(a)(1), portfolio holdings means the securities, assets or other positions held by the exchange-traded fund.

Under Rule 6c-11(c)(1), each business day, an exchange-traded fund must disclose prominently on its website, which is publicly available and free of charge, six categories of information. Under Rule 6c-11(c)(1)(i), the first category is, before the opening of regular trading on the primary listing exchange of the exchange-traded fund shares, the following information (as applicable) for each portfolio holding that will form the basis of the next calculation of current net asset value per share: ticker symbol; CUSIP or other identifier; description of holding; quantity of each security or other asset held; and percentage weight of the holding in the portfolio.

While some actively managed ETFs are required to disclose their holdings on a daily basis, others disclose such information periodically like mutual funds.

Costs

All ETPs have fees and expenses. In addition to any brokerage commission that an investor might pay, ETPs have expense ratios, like mutual funds, calculated as a percentage of the assets invested, but they don’t have loads or 12b-1 fees.

Passive management usually translates into less trading of the fund’s portfolio (lower transaction costs), more favorable income tax consequences (lower realized capital gains), and lower fees and expenses than actively managed funds.

Actively managed funds historically have had higher management fees than passively managed funds. Actively managed products might have higher expense ratios than similar products tracking an index, which has the potential to eat into returns over time.

In addition, more active management of portfolio assets often leads to higher turnover costs (the costs of buying and selling investments in the portfolio) and potentially negative federal income tax consequences.

But fees and expenses for ETPs can vary widely, and some indexes also include embedded costs, which can add up over time. Over time, higher fees and expenses can significantly lower investment returns.

Passive investors might have lower costs because they don’t need to pay for the research, analysis and other costs involved in active management. Fewer trades also typically means fewer transaction fees. However, while low and zero commissions are available, all trading involves some fees, such as those related to bid-ask spreads and markups/markdowns and mutual fund sales loads.

Taxes

Mutual fund investors holding shares in a taxable account generally have to pay taxes on any capital gains distributions they receive from the mutual fund. ETF investors holding shares in a taxable account may also have to pay taxes on any capital gains distributions from the ETF.

However, because many ETFs buy and sell portfolio securities in in-kind exchanges (rather than for cash), they typically have fewer capital gains distributions, and thus lower taxes, than mutual funds. ETFs generally give investors more control over their tax liability.

While taxes on certain ETFs have historically been lower than those for mutual funds, there is no tax difference between an ETF and a mutual fund if the investment is held in a tax-advantaged account.

Though every individual’s circumstances are different, fewer transactions can potentially mean less complicated taxes for passive investors in taxable accounts.

Non-Traditional Index ETFs

Some index mutual funds and exchange-traded funds (ETFs) use more complex or targeted investing strategies than have been traditionally associated with index funds. Unlike traditional index funds, which track a market index, these funds use custom-built indexes to select the fund’s investments.

The custom-built indexes are constructed using criteria that a manager might consider when actively managing investments in a fund. But non-traditional index funds are still “passively managed.” The investment adviser seeks to track an index, rather than using its own independent judgment to manage the fund’s investments.

Non-traditional indexes might include some criteria that an active fund manager would consider, such as choosing components based on valuation, earnings growth and other factors. But funds tracking these indexes are passively managed, meaning they don’t use a fund manager’s independent judgment to manage investments day-to-day.

Such funds that include active characteristics but are passively managed are sometimes referred to as being “quasi-active.”

Unlike most traditional indexes, which are weighted by market capitalization, smart beta funds screen and weight securities using other rules-based factors. Some of these funds track an equal-weighted index in which all companies have an equal representation regardless of market value.

A factor is a characteristic or feature that is believed to cause certain types of securities to outperform or underperform the market as a whole.

Non-traditional index funds have unique characteristics and risks. In some cases, they may be complex and difficult to understand. These funds may have some features of active management, including seeking to outperform the market. But, these funds will not necessarily outperform the market or even perform comparably to the market. In addition, these funds may have limited performance histories. It may not be clear how they will perform under different market conditions. But, these funds typically have higher expenses than traditional index funds.

Non-traditional indexes can be tracked by a variety of products, including mutual funds or exchange-traded products (ETPs), as well as other instruments like structured notes. Other products, such as structured retail products and leveraged or inverse funds, often referred to as “geared” ETPs, can track the performance of non-traditional indexes as well.

Risk and Performance

Like any investment, index funds involve risk. An index fund will be subject to the same general risks as the securities in the index it tracks.

Like all investment products, both mutual funds and ETFs can lose money, and how a fund performed in the past isn’t an indication of how it will perform in the future.

With passive investing, the goal is to recreate market performance over time rather than beat it. Consequently, passive investors tend to invest in funds designed to track a benchmark, such as the S&P 500, and they aim to stay invested through market ups and downs.

Using multiple index funds tracking different indexes can add another layer of diversification. Passive investors can schedule a date (say annually) to rebalance their portfolios to bring them back to their desired asset mix since investments don’t always move together over time.

Some of the indexes and investment strategies used by ETPs can be quite sophisticated and might not have much performance history or, in some cases, easily accessible information.

Exam Relevance

Candidates should check the current outline for their examination.

The SIE Exam content outline lists, in Section 2, Understanding Products and Their Risks, Topic 2.1.9, Exchange-traded Products (ETPs). Types of ETPs lists exchange-traded funds (ETFs) and exchange-traded notes (ETNs) beneath it. The knowledge bullets for that topic list alternative investments to mutual funds, fee considerations, and active vs. passive.

The SIE Exam content outline lists, in Section 3, Understanding Trading, Customer Accounts and Prohibited Activities, Topic 3.1.2, Investment Returns, the bullet Benchmarks and indices.

The SIE Exam content outline lists, in Section 2, Topic 2.1.4, Packaged Products, the bullet Investment companies, with Types of investment companies beneath it: closed-end funds, open-end funds, unit investment trusts (UITs), and variable contracts/annuities. The knowledge bullets for that topic include costs and fees.

The Series 7 content outline lists, in Function 3, Section 3.2, Reviews and analyzes customers’ investment profiles and product options to determine that investment recommendations meet applicable standards, under Packaged products, the bullet Investment companies, exchange-traded funds (ETFs), unit investment trusts (UITs).

Common Misunderstandings

A passive ETF has no investment adviser. The combined securities and other assets the ETF owns are known as its investment portfolio, which is usually managed by an SEC-registered investment adviser. For an index-based ETF, the adviser seeks to track an underlying securities index and achieve returns that closely correspond to the returns of that index.

A passive ETF always matches its index exactly. An index fund may not perfectly track its index. Most ETPs are designed to track the performance of an underlying index; however, sometimes their performance may diverge.

A passive ETF carries no market risk. An index fund will be subject to the same general risks as the securities in the index it tracks.

Every passive ETF tracks a broad market index. Other ETPs track indexes that are more narrowly focused, such as those made up of companies in a specific industry sector or country, corporate bonds with particular credit ratings, or individual commodities or currencies.

An actively managed ETF always outperforms its benchmark. An actively managed fund has the potential to outperform the market or its chosen benchmark, but its performance is heavily dependent on the skill of the manager.

An actively managed ETF is free to ignore its investment objective. But the investments must be consistent with the overall investment objective and strategies of the fund.

Passive ETFs always cost less than actively managed ETFs. In general, actively managed products, including ETFs, might have higher expense ratios than similar index-tracking products. But fees and expenses for ETPs can vary widely, and some indexes also include embedded costs, which can add up over time.

A smart beta ETF is an actively managed ETF. But non-traditional index funds are still “passively managed.”

Rule 6c-11 applies only to index-based ETFs. Under Rule 6c-11(a)(1), exchange-traded fund means a registered open-end management company that issues (and redeems) creation units to (and from) authorized participants in exchange for a basket and a cash balancing amount if any, and whose shares are listed on a national securities exchange and traded at market-determined prices. Index-based and actively managed ETFs that comply with the rule’s conditions function similarly with respect to operational matters, despite different investment objectives or strategies.

An ETF never makes capital gains distributions. ETF investors holding shares in a taxable account may also have to pay taxes on any capital gains distributions from the ETF.

Key Points to Retain

ETFs either passively track the performance of an underlying index or other benchmark or are actively managed investments. A passive strategy seeks to achieve approximately the same return as a particular index. An active strategy relies on the skill of an investment manager to create and manage the fund portfolio in line with the fund’s overall investment objective.

For an actively managed ETF, the adviser buys or sells components in the portfolio without regard to conformity with an index. But the investments must be consistent with the overall investment objective and strategies of the fund.

Passive management usually translates into less trading of the fund’s portfolio (lower transaction costs), more favorable income tax consequences (lower realized capital gains), and lower fees and expenses than actively managed funds. Actively managed products might have higher expense ratios than similar products tracking an index, which has the potential to eat into returns over time.

Tracking error occurs when the returns of the ETP deviate from the returns of its underlying benchmark, which can impact investor performance (either negatively or positively).

The custom-built indexes are constructed using criteria that a manager might consider when actively managing investments in a fund. But non-traditional index funds are still “passively managed.” The investment adviser seeks to track an index, rather than using its own independent judgment to manage the fund’s investments.

The SIE Exam content outline lists active vs. passive among the knowledge bullets for Topic 2.1.9, Exchange-traded Products (ETPs).