What Is a Passively Managed Fund?

Learning the Basics of Index Investing

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When you hear or read about passively managed funds, what does it mean? Are these funds the same as index funds? What are the benefits of passive management?

In this article, we highlight why passively-managed index funds can be advantageous, as opposed to actively-managed funds.

Passively Managed Funds Definition and Basics

A passively managed fund typically tracks a market index, such as the S&P 500, but also may track a particular sector or part of the market. The reason these funds are described as passive is because there is no active strategy for the fund manager(s) to buy and sell securities at their discretion. Instead, the fund manager buys and holds securities of a benchmark index.

Index funds in the pure sense of the term are passively managed. But a passively managed fund isn't necessarily an index fund by definition. Let's take a closer look at this to clarify the difference and similarity. The common thread between a passively managed index fund and a non-index passively managed fund is that the fund managers follow predetermined guidelines for the holdings of their respective funds. Index funds are considered to be passively managed funds.

For example, 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. 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. In both cases, the portfolio manager of the fund does not make "active" decisions of what securities to own.

Most passively-managed funds share two advantages over actively-managed funds. Typically passively managed funds have lower expense ratios and lower capital gains distributions. Therefore passively managed funds also will typically provide more tax-efficiency, which is to say they will often generate fewer taxes for the investor than their actively-managed counterparts.

Types of Indexes or Indices

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 the various sectors, such as utilities, technology, healthcare, financials, and precious metals.

But again, there are some passively managed funds that do not track an actual index. Instead, they are designed to passively follow a target allocation or certain pre-selected group of securities. This makes them index funds with an active element. These funds are sometimes called enhanced index funds.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.