Why ETFs are at the forefront of passive management

Many investors want to beat the market to generate profits. ETFs, which offer passive management, are ideally suited to this mindset.

"Index funds are listed on a continuous basis and traded on the stock exchange in the same way as shares. Whatever the management set up, they always have the same objective : to replicate upwards or downwards the evolution of the underlying (index or assets)" : this is how the AMF (Autorité des Marchés Financiers) defines ETFs. To go further, this article proposes to see why, and how to invest in these funds like no other.  

What is an ETF ?

Definition of ETFs

Also known as Trackers, ETFs (Exchange-Traded Funds) are investment funds whose objective is to replicate the performance of a given stock market index.

To do this, this type of investment fund - called an index fund - is made up of financial assets (usually stocks and/or bonds) specific to several hundred companies. By replicating the results of each asset making up a stock market index, ETFs also replicate the performance of the index. The stated objective of ETFs is not to beat the market but to replicate its performance: they are therefore a passive management tool, since they follow price fluctuations. In this way, the risk of loss is greatly reduced, and this is the charm of this type of investment fund, which is the reason for its expansion in the financial markets.  

These trackers have several major qualities :

  • ETFs can be traded at any time thanks to their continuous quotation
  • ETFs benefit from constant liquidity maintained by the issuing companies
  • ETFs faithfully reproduce market performance through diversification
  • ETFs have low fees because there is no intermediary in their management

Note : ETFs are currently more widely recognised in the US, where they account for 45% of passive management in the financial markets, compared with only 25% in Europe. However, these figures are constantly changing.  

The different types of ETFs

ETFs can reflect developments in a sector of activity as well as in a country or other geographical area. 

There are several types of ETFs on the financial markets :

  • Classic passively managed ETFs
  • Actively managed ETFs, where the fund managers themselves choose the assets that will make up the basket. Fees are higher, which is why these ETFs represent only a minority of investments
  • Eco-responsible ETFs 
  • Government bond ETFs, made up of Treasury bills issued by the government. They represent the bond debt of several selected countries
  • Smart Beta ETFs, which depend on criteria other than the market capitalisation of the companies in the indices concerned

Warning : although they unofficially replicate the performance of an index, Closet Indexing is not an ETF category !  

ETF replication methods

Because the way in which a given index is replicated differs from one index to another, there are various replication methods used by ETFs in order to replicate the performance of a given market as closely as possible :

  • Direct replication (also called physical replication) is the simplest. It directly replicates the performance of all the companies represented by the stock market index
  • Partial physical replication (also called sampled or optimized) is used when the index to be replicated is too complex. A representative sample is then used
  • Indirect replication (also known as partially synthetic replication) involves buying stocks outside the desired index and then exchanging their performance for the index in question. This is a good practice as it allows the investor to take a position on indexes outside Europe

Investing in ETFs

How to invest in ETFs

There are many ways to buy ETFs, just as there are many investment strategies available to you. To begin with, note that ETFs are bought on the stock market (generally via Euronext for France) and that there are two main ways to acquire them :

  • By going through a broker or a bank;
  • By going through a financial investment advisor.

Among the subsidiaries of European banks distributing ETFs are

  • Lyxor (Société Générale)
  • Amundi (Crédit Agricole) 
  • iShares (BlackRock) 
  • UBS
  • Db-X Trackers (Deutsche Bank).

In order to refine your selection, sites like Morningstar allow you to filter ETFs by issuer.  

Good to know : in all cases, ETFs are very similar in terms of performance.  

When it comes to investing, ETFs have three significant advantages :

  • It is possible to invest in ETFs via all tax wrappers (securities account, PEA, life insurance)
  • It is possible to buy and sell throughout the day
  • ETF management fees are up to 5 times cheaper than for traditional funds

Various strategies are used in ETF investing :

  • Geographic diversification : this involves investing in various regions with varying potential (United States, Europe, emerging countries, etc.)
  • Tactical strategy : this involves betting on the short-term performance of assets
  • The Mixed Strategy : this involves composing ETFs with both stocks and bonds
  • Thematic Strategy : this involves focusing on the growth potential of a particular sector
  • Portfolio hedging : this involves buying ETFs short, i.e. in a sell position

Please note : whatever your strategic decision, make sure you only select ETFs with a minimum of €100 million in assets to limit liquidity risks and management fees.  

Traditional or Index Funds

Compared to investing in traditional funds, ETFs have several advantages:

  • Their performance is more predictable
  • Their composition is more transparent
  • Their choice is easier (no stock picking)
  • Their passive management implies low costs (no intermediary)
  • Their composition limits the risk of loss of a single company

Most of these qualities are ultimately based on the fact that ETFs offer passive management which aims not to beat, but to replicate as closely as possible the performance of the selected financial market.  

ETFs: what are the risks ?

There are three main risks to investing in ETFs :

  • Collateral risk : this arises from a partial failure of the index fund
  • Liquidity risk : this arises from the difficulty of finding a buyer or seller for a given product
  • Decorrelation risk : this arises from the mismatch between the value of the index and that of the ETF in question

Good to know : in the latter case, the role of Authorised Participants and Market Makers is to ensure that the match between the index value and the intrinsic value of the ETF remains optimal.  

In practice, the maximum difference between the value of ETFs and their index is 0.2%. However, safeguards theoretically limit this gap to 1.5% even in the event of a financial crisis.  


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The ETF market

ETFs on the stock market

ETFs are an option that has become increasingly important in the financial markets over time, so much so that today they have a weighting of approximately $7 trillion that can be found in several forms :

  • Passive ETFs (69%)
  • Active ETFs (16%) 
  • Smart Beta (15%)

According to the JP Morgan study, active ETFs are currently gaining ground in the financial markets.  

ETFs by sector

There are many sectors in which it is possible to invest in ETFs :

  • Stock market indexes (CAC 40, DAX 30, S&P 500, Nasdaq, etc.)
  • Sector indices (industry, technology, telecommunications, health, etc.) 
  • Raw materials 
  • Corporate bonds
  • Real estate

ETFs around the world

In 1990, the first listed tracker appeared in Canada. Three years later, the SPY Tracker, which replicates the performance of the S&P 500, was created and proved its effectiveness. Since then, ETFs have continued to grow and now represent 8% of global capitalisation and 1.1% of European equities according to the AMF. There are more than 7,000 ETFs worldwide, including 2,500 in Europe and 500 on the Paris stock exchange, via Euronext. On the ETF market, the SPDR S&P 500 ETF Trust currently has the largest amount outstanding, i.e. more than 200 billion dollars of traded capital worldwide!

ETFs are a simple and effective solution for generating long-term profits on the financial markets. Aimed at both professional and amateur investors, their objective is to replicate the performance of a given stock market index. Thus, risk and management fees are both limited. Despite the advantages of passive management, there has been a recent trend among investors to turn to active ETFs : it seems that the desire to beat the market via other trading strategies is still very attractive.