Debunking 3 common misconceptions about passive investing

Why the striking difference? Because in adhering to the IRS rule, the Vanguard ETF had to sacrifice some of its weightings across its top three holdings; as a result, the ETF underperformed relative to the sector index by approximately 8%.³

To further this point, however, some industry-specific index funds may not proportionately reflect market leaders in the sectors they claim to represent. If you’re seeking to gain exposure to a specific industry sub-sector like U.S. homebuilders, for example, you might want to delve into index-tracking funds’ underlying stock weightings: Some specialized index funds may diversify away from core industry holdings and overweight related—but not industry-specific—companies.

At the beginning of 2024, for example, home furnishings company William-Sonoma was the largest single stock exposure in SPDR S&P Homebuilders ETF, a fund focused on the U.S. homebuilding industry. If you’re an investor seeking specialized market exposures, it pays to look closely at your passive funds’ actual weightings; you may need a more customized investment vehicle that caters to the specific exposures required to meet your complex financial goals.⁴

Myth 2: “Passive strategies are typically the cheapest investment option”

While passive strategies are typically low cost, not all index funds have lower expense ratios than their active counterparts. In fact, the more specialized a passive ETF you seek, the more expensive it may be. Understanding the costs associated with different investment options can be complex. On average, ETFs have expense ratio of 0.52%, while mutual funds average 0.85%.⁵

In the realm of passive index funds, the cheapest options tend to be found in the most broad-based, generic funds available in the marketplace. As the investment focus narrows to a particular industry sector or geographic region, fees can often start to climb. In some cases, specialized passive investing may be more expensive than some investors anticipate. Gaining passive exposure to niche parts of the market (Japanese equity, for example), can be quite costly. Thus, there are trade-offs to consider.⁶

Before investing in any passive investment strategy, it’s a good idea to assess its fees and evaluate its holdings. Doing your homework is key to making sure that you know exactly what you’re paying for—and spending fees on what you actually want to get.

Myth 3: “Passive strategies are universally tax efficient”

Some investors also assume that—given their cost structure—passive ETFs are the most tax efficient strategies, too. Passive ETFs can be tax-efficient due to their ability to defer gains. Using separately managed accounts (SMAs), however, allows direct ownership of each stock, which gives investors the flexibility to “harvest” tax losses—an important tax-saving option—and gift tax-efficiently to charities using the underlying holdings.

As a means of achieving greater tax efficiency, tax loss harvesting is a powerful tool: Designed to potentially lower your tax bill, this approach works by capturing losses throughout the year that your manager can use to offset gains in your portfolio. Additionally, those losses can be leveraged to smooth gains at any time—there is no waiting until year end to match one to the other.

As an investor, you might want to consider entrusting your investment portfolio to a professional manager to simplify the process of managing losses. This approach can be especially useful for improving tax efficiency, particularly in unpredictable markets where trends are not clear.

Conclusion: Looking below the surface of passive investing

As the market for passive investment strategies continues to evolve, it’s crucial to look below the surface and understand the nuances that could impact your financial future. While passive ETFs and index funds offer competitive and appealing benefits, they are not a one-size-fits all strategy. By exploring the underlying facts about each passive investment and considering more tailored approaches, you can make more informed decisions that align with your wealth goals.

We can help

At J.P. Morgan, we understand that each client's financial journey is unique. Our personalized financial advice is designed to tailor investment strategies to your individual goals and circumstances. Whether you're considering passive or managed strategies, it’s important to make informed decisions and ensure that your investments align with your objectives. By taking prudent financial advice, you can achieve cost-effective and tax-efficient investment outcomes.

If you’d like us to explore how these strategies could support you in realizing your wealth goals, speak with your J.P. Morgan team. We're here to help you navigate your financial path with confidence.

¹So popular are these vehicles, total assets under management in passive investment funds in the United States surpassed those held in actively managed funds for the first time in late 2023, according to data from Morningstar, Inc.

²These large-cap tech companies are often referred to as the “Magnificent 7,” a play on the 2016 movie of the same title, and typically include Apple Inc., Microsoft Corporation, Amazon.com, Inc., Alphabet Inc., Meta Platforms, Inc., Nvidia Corporation and Tesla, Inc.

³SOURCE Bloomberg; data as of September 30, 2024. 

⁴SPDR S&P Homebuilders ETF, for example, only holds a 35% weighting in homebuilding companies; most of its largest holdings are construction-related stocks, and its biggest single holding is American boiler manufacturer A.O. Smith Corporation (as of October 30, 2024).

⁵Morningstar Direct. Data as of August 13, 2024. Average Prospectus Net Expense ratio for index ETFs and open end Index mutual funds as defined by Morningstar.

⁶Source iShares. Data as of December 2024.