Why do passive ETFs require so much trading (and incur costs)?
Now, if I'm not mistaken, tracking a value-weighted index is extremely easy - just buy the shares in the exact amount they are in the index and wait. Yes in theory. In practise this is difficult. Most funds that track S&P do it on sample basis. This is to maintain the fund size. Although I don't have / know the exact number ... if one wants to replicate the 500 stocks in the same %, one would need close to billion in fund size. As funds are not this large, there are various strategies adopted, including sampling of companies [i.e. don't buy all]; select a set of companies that mimic the S&P behaviour, etc. All these strategies result in tracking errors. There are algorithms to reduce this. The only time you would need to rebalance your holdings is when there is a change in the index, i.e. a company is dropped and a new one is added, right? So essentially rebalance is done to; If so, why do passive ETFs require frequent rebalancing and generally lose to their benchmark index? lets take an Index with just 3 companies, with below price. The total Market cap is 1000  The Minimum required to mimic this index is 200 or Multiples of 200. If so you are fine.    More Often, funds can't be this large. For example approx 100 funds track the S&P Index. Together they hold around 8-10% of Market Cap. Few large funds like Vangaurd, etc may hold around 2%. But most of the 100+ S&P funds hold something in 0.1 to 0.5 range. So lets say a fund only has 100. To maintain same proportion it has to buy shares in fraction. But it can only buy shares in whole numbers. This would then force the fund manager to allocate out of proportion, some may remain cash, etc. As you can see below illustrative, there is a tracking error. The fund is not truly able to mimic the index.  Now lets say after 1st April, the share price moved, now this would mean more tracking error if no action is taken [block 2] ... and less tracking error if one share of company B is sold and one share of company C is purchased.  Again the above is a very simplified view. Tracking error computation is involved mathematics.  Now that we have the basic concepts, more often funds tracking S&P; Thus they need to rebalance.
"Funds which track the same index may have different nominal prices.  From an investors point of view, this is not important.  What is important is that when the underlying index moves by a given percentage, the price of the tracking funds also move by an equal percentage.  In other words, if the S&P500 rises by 5%, then the price of those funds tracking the S&P500 will also rise by 5%.  Therefore, investing a given amount in any of the tracking funds will produce the same profit or loss, regardless of the nominal prices at which the individual funds are trading. To see this, use the ""compare"" function available on the popular online charting services. For example, in Google finance call up a chart of the S&P500 index, then use the compare textbox to enter the codes for the various ETFs tracking the S&P500.  You will see that they all track the S&P500 equally so that your relative returns will be equal from each of the tracking funds.  Any small difference in total returns will be attributable to management fees and expenses, which is why low fees are so important in passive investing." First, make sure you understand the objective of an ETF.  In some cases, they may use leverage to get a multiple of the index's return that is different than 1.  Some may be ultra funds that go for double the return or double the inverse of the return and thus will try to apply the appropriate leverage to achieve that return. Those that use physical replication can still have a small portion be used to try to minimize the tracking error as there is something to be said for what kind of tracking error do you accept as the fund's returns may differ from the index by some measure. Yes.  For example, if you were to have a fund that had a 50% and -50% return in back to back periods, what would your final return be?  Answer: -25%, which if you need to visualize this, take $1 that then becomes $1.50 by going up 50% and then becomes $.75 by going down 50% in a compounded fashion.  This is where you have to be careful of the risks of leverage as those returns will compound in a possibly negative way. - ETFs make money through management fees. You can look it up: they all skim off a little bit of its profit, normally &lt;1%.  - It's all about cheap diversification. People generally don't have the capital to invest individually in each equity to mimic an ETF's portfolio.   - Yes, but you need a lot of money. For example: You can't just invest $1 in GOOG if you want to buy a tech sector ETF. "A huge amount of money in all financial markets is from institutional investors, such as mutual funds, government pension plans, sovereign wealth funds, etc.  For various reasons these funds do all of their trading at the end of the day.  They care primarily that their end-of-day balances are in line with their targets and are easy to audit and far less about ""timing the market"" for the best possible trades. So, if you're looking at a stock that is owned by many institutional investors -- such as a stock (like AAPL) that makes up a significant portion of an index that many funds track -- there will be a huge amount of activity at this time relative to stocks that are less popular among institutions. Even just in its introduction this paper (PDF) gives a fair overview of other reasons why there's a lot of trading at end-of-day in general. (In fact, because of all this closing activity and the reliance on end-of-day prices as signposts for financial calculations, the end-of-day has for decades been the single most fraud-ridden time of the trading day.  Electronic trading has done away with a lot of the straight-up thievery that floor traders and brokers used to get away with at the expense of the public, but it still exists.  See, for example, any explanation of the term banging the close, or the penalties against 6 banks just last month for manipulating the FX market at the close.)" I agree. Small investors got screwed worse with manually traded shares. Electronic trading was a big part of why fees for trades have come down so much over the years. HFT acts as a tax on small traders, but it is fairly insignificant.  This isn't to say that HFT isn't a problem. Systems that cause flash crashes with no one understanding why, isn't good for the market. A small fee is a small change that could provide a solution to the problem. Agree with Michael here. The exchanges help you more than they will hurt. It begs the question why you want to avoid exchanges and the brokers since they do provide a valuable service. If you want to avoid big fees, most of the discount brokerages have tiny fees these days (optionshouse is down to $4), plus many have deals where you get 60 or more trades for free. "In an attempt to express this complicated fact in lay terms I shall focus exclusively on the most influential factor effecting the seemingly bizarre outcome you have noted, where the price chart of VIX ETFs indicates upwards of a 99% decrease since inception. Other factors include transaction costs and management fees.  Some VIX ETFs also provide leveraged returns, describing themselves as ""two times VIX"" or ""three times VIX"", etc. Regarding the claim that volatility averages out over time, this is supported by your own chart of the spot VIX index. EDIT It should be noted that (almost) nobody holds VIX ETFs for anything more than a day or two.  This will miminise the effects described above.  Typical daily volumes of VIX ETFs are in excess of 100% of shares outstanding.  In very volatile markets, daily volumes will often exceed 400% of shares outstanding indicating an overwhelming amount of day trading." "Don't put money in things that you don't understand. ETFs won't kill you, ignorance will. The leveraged ultra long/short ETFs hold swaps that are essentially bets on the daily performance of the market. There is no guarantee that they will perform as designed at all, and they frequently do not. IIRC, in most cases, you shouldn't even be holding these things overnight. There aren't any hidden fees, but derivative risk can wipe out portions of the portfolio, and since the main ""asset"" in an ultra long/short ETF are swaps, you're also subject to counterparty risk -- if the investment bank the fund made its bet with cannot meet it's obligation, you're  may lost alot of money. You need to read the prospectus carefully. The propectus re: strategy. The Fund seeks daily investment results, before fees and expenses, that correspond to twice the inverse (-2x) of the daily performance of the Index. The Fund does not seek to achieve its stated investment objective over a period of time greater than a single day. The prospectus re: risk. Because of daily rebalancing and the compounding of each day’s return over time, the return of the Fund for periods longer than a single day will be the result of each day’s returns compounded over the period, which will very likely differ from twice the inverse (-2x) of the return of the Index over the same period. A Fund will lose money if the Index performance is flat over time, and it is possible that the Fund will lose money over time even if the Index’s performance decreases, as a result of daily rebalancing, the Index’s volatility and the effects of compounding. See “Principal Risks” If you want to hedge your investments over a longer period of time, you should look at more traditional strategies, like options. If you don't have the money to make an option strategy work, you probably can't afford to speculate with leveraged ETFs either." "Are you talking long-term institutional or retail investors? Long-term *retail* investors look for *orderly markets*, the antithesis of HFT business models, which have a direct correlation between market volatility and profits. To a lesser extent, some ""dumb money""/""muppet"" institutionals do as well. HFT firms tout they supply liquidity into markets, when in fact the opposite is true.  Yes, HFTs supply liquidity, *but only when the liquidity's benefits runs in their direction*. That is, they are applying the part of the liquidity definition that mentions ""high trading activity"", and conveniently ignoring the part that simultaneously requires ""*easily* buying *or* selling an asset"".  If HFT's are the new exchange floor, then they need to be formalized as such, *and become bound to market maker responsibilities*. If they are actually supplying liquidity, like real Designated Market Makers in the NYSE for example, they become responsible to supply a specified liquidity for specified ticker symbols in exchange for their informational advantage on those tickers. The indisputable fact is that HFT cannot exist at their current profit levels without the information advantage they gain with preferential access to tick-by-tick data unavailable to investors who cannot afford the exchange fees ($1M per exchange 10 years ago, more now). Restrict the entire market, including HFTs, to only second-by-second price data without the tick-by-tick depth, and they won't do so well.  Don't get me wrong, I'm not knocking HFTs *per se*; I think they are a marvelous development, so long as they really do ""supply liquidity"". Right now, they aren't doing so, and especially in an orderly manner. If you want retail investors to keep out of the water as they are doing now, by all means let HFT (and regulatory capture, and a whole host of other financial service industry ills) run as they are. There are arguments to be made about ""only let the professionals play the market"", where there is no role for retail and anyone who doesn't know how to play the long-term investment game needs to get out of the kitchen. But if you are making such an argument, come out and say so." index ETF tracks indented index (if fund manager spend all money on Premium Pokemon Trading Cards someone must cover resulting losses) Most Index ETF are passively managed. ie a computer algorithm would do automatic trades. The role of fund manager is limited. There are controls adopted by the institution that generally do allow such wide deviations, it would quickly be flagged and reported. Most financial institutions have keyman fraud insurance. fees are not higher that specified in prospectus Most countries have regulation where fees need to be reported and cannot exceed the guideline specified. at least theoretically possible to end with ETF shares that for weeks cannot be sold Yes some ETF's can be illiquid at difficult to sell. Hence its important to invest in ETF that are very liquid. "If anything, the price of an ETF is more tightly coupled to the underlying holdings or assets than a mutual fund, because of the independent creation/destruction mechanism. With a mutual fund, the price is generally set once at the end of each day, and the mutual fund manager has to deal with investments and redemptions at that price. By the time they get to buying or selling the underlying assets, the market may have moved or they may even move the market with those transactions. With an ETF, investment and redemption is handled by independent ""authorized participants"". They can create new units of the ETF by buying up the underlying assets and delivering them to the ETF manager, and vice versa they can cancel units by requesting the underlying assets from the ETF manager. ETFs trade intraday (i.e. at any time during trading hours) and any time the price diverges too far from the underlying assets, one of the authorized participants has an incentive to make a small profit by creating or destroying units of the ETF, also intraday." what reason would I have in buying an ETF? Apart from the efforts, the real reason is the ticket size. One can't buy shares in fraction. To truly reflect the index in equal weight, the amount to invest will be in multiples of millions [depending on the Index and the stock composition]   This related question should help you understand why it is difficult even for large fund house to exactly mimic the index. Why do passive ETFs require so much trading (and incur costs)? Powers makes a good point: trading costs may eat up a significant portion of your ROI. A fee as little as 2% can consume more than 50% of your long-term ROI! A rule of thumb is keep your fees to less than 1%. One way to do that is to buy stock in companies that have a DRIP with a Share Purchase Plan (SPP). Often the SPP allows investors to purchase shares for low fees or free. Once you have the ability to purchase shares for (virtually) free, you can  use InvestMete. Roughly, you send more money to the companies whose share prices are near their 52-week low, and less money to those who are near their 52-week high. Getting back to your original question... That is such a vague statement, I highly recommend disregarding it entirely, as it is impossible to know what they meant. Their goal is to convince you that index funds are the way to go, but depending on what they consider an 'active trader', they may be supporting their claim with irrelevant data Their definition of 'active trader' could mean any one or more of the following: 1) retail investor 2) day trader 3) mutual fund 4) professional investor 5) fund continuously changing its position 6) hedge fund. I will go through all of these. 1) Most retail traders lose money. There are many reasons for this. Some rely on technical strategies that are largely unproven. Some buy rumors on penny stocks in hopes of making a quick buck. Some follow scammers on twitter who sell newsletters full of bogus stock tips. Some cant get around the psychology of trading, and thus close out losing positions late and winning positions early (or never at all) [I myself use to do this!!]. I am certain 99% of retail traders cant beat the market, because most of them, to be frank, put less effort into deciding what to trade than in deciding what to have for lunch. Even though your pension funds presentation is correct with respect to retail traders, it is largely irrelevant as professionals managing your money should not fall into any of these traps. 2) I call day traders active traders, but its likely not what your pension fund was referring to. Day trading is an entirely different animal to long or medium term investing, and thus I also think the typical performance is irrelevant, as they are not going to manage your money like a day trader anyway. 3,4,5) So the important question becomes, do active funds lose 99% of the time compared to index funds. NO! No no no. According to the WSJ, actively managed funds outperformed passive funds in 2007, 2009, 2013, 2015. 2010 was basically a tie. So 5 out of 9 years. I dont have a calculator on me but I believe that is less than 99%!   Whats interesting is that this false belief that index funds are always better has become so pervasive that you can see active funds have huge outflows and passive have huge inflows. It is becoming a crowded trade. I will spare you the proverb about large crowds and small doors. Also, index funds are so heavily weighted towards a handful of stocks, that you end up becoming a stockpicker anyway. The S&P is almost indistinguishable from AAPL. Earlier this year, only 6 stocks were responsible for over 100% of gains in the NASDAQ index. Dont think FB has a good long term business model, or that Gilead and AMZN are a cheap buy? Well too bad if you bought QQQ, because those 3 stocks are your workhorses now. See here 6) That graphic is for mutual funds but your pension fund may have also been including hedge funds in their 99% figure. While many dont beat their own benchmark, its less than 99%. And there are reasons for it. Many have investors that are impatient. Fortress just had to close one of its funds, whose bets may actually pay off years from now, but too many people wanted their money out. Some hedge funds also have rules, eg long only, which can really limit your performance. While important to be aware of this, that placing your money with a hedge fund may not beat a benchmark, that does not automatically mean you should go with an index fund. So when are index funds useful? When you dont want to do any thinking. When you dont want to follow market news, at all. Then they are appropriate. The key two things to consider when looking at similar/identical ETFs is the typical (or 'indicative') spread, and the trading volume and size of the ETF. Just like regular stocks, thinly traded ETF's often have quite large spreads between buy and sell: in the 1.5-2%+ range in some cases. This is a huge drain if you make a lot of transactions and can easily be a much larger concern than a relatively trivial difference in ongoing charges depending on your exact expected trading frequency. Poor spreads are also generally related to a lack of liquidity, and illiquid assets are usually the first to become heavily disconnected from the underlying in cases where the authorized participants (APs) face issues. In general with stock ETFs that trade very liquid markets this has historically not been much of an issue, as the creation/redemption mechanism on these types of assets is pretty robust: it's consequences on typical spread is much more important for the average retail investor. On point #3, no, this would create an arbitrage which an authorized participant would quickly take advantage of. Worth reading up about the creation and redemption mechanism (here is a good place to start) to understand the exact way this happens in ETFs as it's very key to how they work.