While studying ETFs, I have read several times that they track a specific index. So they are basically index funds on steroids.

I'm wondering why all ETFs work like that. In other words: what are the benefits of tracking an existing index? Why can't a fund manager just pick a bunch of assets (stocks, bonds, whatever he thinks is more appropriate) and make an ETF out of it?

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There are good reasons why a lot of ETFs are passive.

  1. The SEC requires ETF publish holdings on a daily basis. By contrast, for mutual fund it's quarterly. That makes active management a lot harder since you can't keep what you are doing a secret.

  2. ETF for the most part does not charge 12b-1 fee - a fee that is used to pay for marketing and distribution costs. The majority of active management is sold, not bought, unlike index based ETFs.

  3. In a bull market, actively managed fund is just not that appealing. When you can own an S&P 500 ETF for as low as 4-5 bps and enjoy double digit returns, you probably wouldn't bother looking for something that may or may not beat the market and would charge you extra.

An ETF is an exchange traded fund. Any fund that can be bought on major exchanges will have more flexibility and liquidity because it can be bought and sold in real time. Index funds are popular because they have low management fees, but there's no reason any other managed fund wouldn't benefit from benefit from being traded on an exchange.

ETFs can be actively managed; there is nothing in their structure that would prohibit this. Here is a list of them.

I wouldn't say typical ETFs are index funds on steroids. They are just regular index funds that operate under a slightly different regulatory regime.

ETFs (and all funds) come in kind of three varieties: passive, smart beta, and active. Passive funds have a defined benchmark that they follow so there is little to no work to be done by humans. Active funds are the opposite--fund managers are trading and researching and trying to beat their benchmark. Smart beta funds are in between: the follow a defined algorithm that trades and tries to be smart but has little to no human touch. Any of these could, in principle, be turned into an ETF.

Most ETFs are passive indexers and passive funds have the vast majority of the assets under management. The reason for this is that the mechanism that maintains ETF pricing involves the creation and redemption of new ETF shares in exchange for baskets of the underlying securities of the fund. If the portfolio is being actively traded, it's difficult for the institutions that purchase new shares to gather and deliver the right basket of securities.

Financial innovation is always going on and actively managed ETFs certainly exist. Whether you think they are successful as a group and have much of a future depends on your view of the industry.

Going back to your question, could a manager create a basket of securities and then not change it, so that it would be passive but also not track an index? Sure. The problem is, no one wants that, so the fund would have a very hard time getting off the ground. Indexes are extremely easy to create, so there's already an index for pretty much any passive portfolio an investor would want.

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