A passively managed fund typically tracks a specific industry sector or a market index, such as the S&P 500. There is no active strategy for the fund manager to buy or sell securities.
What Is a Passively Managed Fund?
In a passively managed fund, the manager buys and holds securities of a benchmark index. The fund manager follows the index and does not use their own discretion. The fund is essentially operated on auto-pilot. A passively managed fund is not necessarily an index fund.
How Passively Managed Funds Work
Most passively managed funds share two advantages over actively managed funds. Typically, passively managed funds have lower expense ratios and lower capital gains distributions. That translates into more tax-efficiency for the investor over their actively managed counterparts.
Types of Passively Managed Funds
Here are the types of passively managed funds:
These are the purest form of passively managed funds, because they follow a specific index and are not actively managed. An index fund that attempts to mimic the returns of the S&P 500 will hold the stocks (or most of the stocks) within the S&P 500.
Other indexes (or indices, if you prefer that term) include the Dow Jones Industrial Index, the Barclays Aggregate Bond Index, the Russell 1000 Index, the Russell 2000 Index, the Russell 3000 Index, the S&P 400 Mid-Cap Index, the Wilshire 5000 Index, and several different variations of the MSCI EAFE index.
There are index funds specifically designed to track these indexes. There are also indexes that track various sectors, such as utilities, technology, healthcare, financials, and precious metals.
Vanguard is well known for its low-cost index funds.
Any fund where fund managers follow predetermined guidelines for the holdings also qualifies. A non-index passively managed fund may hold a pre-defined section of an asset class—such as the smallest 25% of the market with the lowest price-to-book ratio. That makes them index funds with an active element, sometimes called "enhanced index funds."
Are Passively Managed Funds Worth It?
A passively managed fund has lower carrying costs, because there is no fund manager making decisions about where to invest the money. It will only perform as well as the underlying index or industry sector. In 2020, passively managed funds still prevailed in performance despite gains by actively managed funds. According to the Morningstar Active/Passive Barometer, 42% of active funds outperformed their passive peers, vs. 49% doing so in 2019.
This makes passively managed funds a suitable choice for conservative investors who have no desire to outperform the market. In 2020, the average expense ratio for an actively managed mutual fund was 0.71%, while the average for a passively managed index equity fund was 0.06%.
- Passively managed funds are designed to follow an index.
- No active decision-making by a fund manager means lower fees.
- Passively managed funds tend to outperform actively managed ones.
- They are good choices for people who aren't looking to beat the market.