How do passive funds work?
Index funds and most ETFs are passive funds that track a certain index.
Passively managed funds aim to keep their portfolio allocation as close to their benchmark index as possible, due to which they are also sometimes called index funds. Many fund management companies offer passively managed index funds, but increasingly when people refer to passive funds, they mean ETFs (exchange traded funds) which, as the name suggests, are traded on a stock exchange just like other securities.
A passively managed fund will trade only when its index is updated to reflect the situation in the markets. This can take place two or four times a year, for example. For this reason, the portfolio manager of a passive fund does not have to conduct a market analysis or apply their view of the market. As a result, the fund’s fees are lower than in actively managed funds, which aim for a higher return than the market average through stock and sector picking.
The name is slightly misleading, however, as the management of every fund involves a certain measure of active decision-making. Even an index fund requires its manager to take a view on such aspects as the criteria for tracking the average performance of the market and on how the index is actually composed.