Understanding Your Passive Investing Options

When you're exploring ways to grow your money with a hands-off approach, you're essentially looking for a passive strategy. This type of investing is popular for good reason, but it's important for anyone to understand the tools available. Generally, you'll come across three main vehicles to build your portfolio and generate : index funds, passive asset-class funds, and exchange-traded funds (ETFs). Let's break down what each one is and how they differ.

What Are Index Funds?

Index funds are the most common starting point for passive investors. The concept is straightforward: the fund buys and holds all the securities that make up a specific market index, like the S&P 500. This is a form of that offers broad market exposure.

However, the fund doesn't own an equal amount of each company. Instead, it uses market-cap weighting, meaning larger companies make up a bigger slice of the portfolio. For instance, in an S&P 500 index fund, the largest company might account for 5% of the fund's total assets. You can find index funds for all sorts of market segments, from large-cap and small-cap stocks to value, growth, and even . There are also options for international and emerging markets.

People are drawn to indexing for a few clear reasons:

: They are generally cheaper to operate than actively managed funds.
: Since they just follow an index, they aren't constantly buying and selling, which keeps costs down.
: Less trading activity typically means fewer taxable events for investors.

When it comes to providers, Vanguard is widely seen as the leader in this space, offering a huge selection at some of the lowest costs. Fidelity's Spartan funds are another excellent, low-cost alternative for those in index funds.

A Deeper Dive: Passive Asset-Class Funds

It helps to think about the relationship between index funds and passive asset-class funds like you would squares and rectangles. Every square is a rectangle, but not every rectangle is a square. Similarly, all index funds are passively managed, but not all passive funds are index funds.

So, in a passive asset-class fund? An asset class is simply a group of securities with similar risk profiles. While an index fund tracks a pre-defined index, a passive asset-class fund can be created around a group of securities even if no official index for them exists. For example, the Bridgeway Ultra-Large 35 Fund holds the 35 largest stocks with equal weighting—it's a passive fund, but it’s not tracking a formal index.

The key advantage here is that these funds aren't forced to perfectly replicate an index and minimize "tracking error." Instead, their goal is to get the best possible returns for the level of risk associated with that asset class. This freedom allows them to avoid some of the rigid rules that can hinder index funds.

Here are a few ways they do that:

: Studies show that initial public offerings often underperform. If a new IPO is added to an index, the index fund has to buy it. A passive asset-class fund can simply screen them out by, for example, only buying stocks that have been publicly listed for at least a year.
: Imagine a stock in the Russell 2000 index (for smaller companies) grows just enough to get kicked out. An index fund must sell it. If it falls back into range the next year, the fund has to buy it back. This is costly. A passive asset-class fund can create a "hold range" to avoid selling a stock just because it temporarily moves out of the buy criteria, which reduces trading costs and improves tax efficiency.
: A tax-managed asset-class fund might hold a stock with short-term gains just long enough for it to qualify for the lower long-term capital gains tax rate. An index fund would have to sell immediately if the stock left the index.

These strategies are especially effective with small-cap stocks, where trading costs are high. An active manager trying to sell a large block of a thinly traded small-cap stock might have to accept a steep discount to sell it quickly. A patient, passive asset-class fund can step in and buy that block at a bargain price, turning the high trading costs of the market into an advantage. These are the kinds of strategies that can enhance .

The top provider here is Dimensional Fund Advisors (DFA), which engineers its funds to capitalize on these opportunities. However, DFA funds aren't available to the general public; you have to go through an approved financial advisor. Bridgeway is another well-regarded firm offering these types of funds.

The Flexible Option: Exchange-Traded Funds (ETFs)

Exchange-traded funds, or ETFs, act a lot like mutual funds but trade on an exchange just like individual stocks. An ETF tracking the S&P 500 will look very similar to an S&P 500 index fund, but its structure offers some unique pros and cons for .

Advantages of ETFs

: Their unique structure often results in fewer taxable distributions compared to traditional index funds.
: Operating costs are typically very low, on par with or sometimes even lower than index funds.
: Since they trade like stocks, non-U.S. residents can usually buy them without the restrictions they might face with U.S. mutual funds.

Disadvantages of ETFs

: Because ETFs trade like stocks, you have to pay the bid-ask spread every time you buy or sell.
: Unlike buying a no-load mutual fund directly from the provider, you'll almost always pay a brokerage commission to trade an ETF. This can add up, especially if you're investing small amounts frequently, like in a dollar-cost-averaging plan.

ETFs are a very suitable tool for building a globally diversified portfolio. The biggest names in the ETF market include Barclays Global Investors, State Street, and Vanguard, which also offers ETF versions of many of its popular index funds.