Approaches to Passive Equity Investing

You've probably heard of Vanguard or iShares, two of the largest passive equity investing firms, which have grown tremendously as passive investing has grown. Typically, these passive investment firms offer mutual funds and exchange-traded funds, which make passive investment easy.

Not surprisingly, this process starts with the investor. What is probably the first step in pooled-vehicle passive investing?

Exactly! Mutual funds and ETFs are pooled investment vehicles because they combine multiple investors into one fund. The passive investment process of a pooled investment vehicle starts in a similar fashion to active management.

Not quite. That sounds like an individual portfolio, which is not an easy way to gain equity exposure.

That's not it. The portfolio is based on the investor.

No. The benchmark is based on the investor, so it's not the first step.

Right. Passive investing still starts with the investor's risk tolerance, constraints, and objectives. That's crucial to ensuring that the investment strategy matches the investor's goals. Then a passive strategy can be implemented, with pooled investments as one option. For mutual funds, shares can be purchased either through the fund directly, through a fund marketplace (a company that offers multiple fund families with a single statement), or through an individual financial adviser, who can provide guidance, a single account, and potentially lower cost shares. But regardless of the purchase approach, there are some great benefits to using mutual funds. Since the mutual fund manager is in charge of tracking the index, the fund handles all the trading, cash handling, corporate actions, proxy voting, and performance reporting. Plus, the fund covers the costs of registration, custodial and auditing.

Given all this work, how do you think mutual fund fees compare to the fees of an individual active manager?

What about margin borrowing would allow ETF investors to structure their specific risk factors?

No. Active managers charge trading fees, commissions, management fees, and overhead, while mutual funds spread those costs over lots of investors.

Not quite. Mutual funds can spread their costs over lots of investors.

Yes! Since margin borrowing is allowed to purchase ETFs, that also means that ETFs can be sold short, which allows investors to take further action to achieve their specific exposure. So that's another benefit in addition to the ease of trading, low management fees, and tax efficiency. Structurally, ETFs are unique in that a fund manager creates or redeems the ETF shares, while an authorized participant delivers assets to the manager. For example, the authorized participant will deliver a basket of the underlying stocks and receive shares of the ETF to sell to the public. When shares are redeemed, the process is reversed, and the authorized participant receives the underlying stocks to sell in exchange for shares of the ETF. From this approach, an ETF will usually have a smaller taxable event than those in a similarly managed mutual fund. Think about the difference between an ETF and a mutual fund, which must sell shares of the underlying stocks to fulfill redemptions. But that's not the process with an ETF.

No. That's not an additional benefit of margin borrowing. In fact, margin borrowing isn't usually allowed in retirement accounts.

That's not it. That would be nice, but ETFs make the investors pay capital gains.

What part of the ETF process helps the investor's tax situation?

Which of the two options do you think offers more flexibility?

No. Any purchase or sale will incur taxation.

No. The investor pays any taxes charged, not the authorized participant.

Not quite. There just aren't as many mutual funds that offer index exposure.

That's not it. One of these vehicles offers significantly more options for index exposure and also has more liquidity.

No. That's a fundamental approach, so it's not a passive strategy.

Right! Mutual funds offer the benefit of being lower cost than active management because they take on all those costs. That's a definite benefit, along with the convenience of the fund structure handling registration issues like who owns shares, what the transaction prices are, and when shares were purchased. In addition to using a mutual fund as a passive investment vehicle, investors can also use an ETF, which offers the additional benefit of being able to be bought and sold throughout the trading day. Investors are also able to use margin borrowing to purchase ETFs, and this allows ETF investors to make additional trades to further structure their exposure to certain factors or risks.

Right! The direct transfer of underlying shares is called an in-kind delivery of stock, and it avoids a recognition of capital gains until the underlying positions are actually sold. That's a definite advantage of ETFs, along with the fact that ETFs far outnumber the amount of mutual funds that track indexes. However, there are disadvantages to ETFs, including buying at the offer, selling at the bid price, paying commission costs, as well as having the risk of illiquid markets and the fact that non-benchmark indexes are captured by ETFs. Despite these risks, ETFs have become a popular way for financial advisers to gain exposure to specific sectors of the investable market while relying upon the fund sponsor to perform the management and accounting. Yet, the final decision between using a mutual fund or an ETF depends upon flexibility and cost.

To summarize: [[summary]]

Clearly, yes! Since ETFs far outnumber mutual funds, they provide greater flexibility along with daily trading, liquidity, and lower fees. But you'll need to be careful when it comes to trading costs, as frequent brokerage trades into ETF shares can negate the expense ratio advantage of ETFs.

Plus, these investment vehicles are a do-it-yourself approach or an active management setup. How might you describe a mutual fund/ETF passive investment vehicle?

Developing the proper passive portfolio

Evaluating the best benchmarks for the investor's portfolio

Understanding the investor's risk tolerance, constraints, and objectives

They're lower

They're higher

They're the same

ETFs can be sold short

ETFs can be bought in retirement accounts

ETFs offer no capital gains tax on long-term gains

The direct transfer of underlying shares

The fact that the authorized participant pays all taxes on gains

The fact that the authorized participant pays all taxes on gains, on the immediate sale, and then on purchase of the underlying shares

ETFs

Mutual funds

Either ETFs or mutual funds

A pooled investment

A collection of individual stocks

A weighted portfolio of underperforming equities

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