Passive ETFs r Active

At least in illiquid market sectors.…
The so-called passive ETFs get active to increase the liquidity of their shares, especially those that track relatively illiquid markets such as small-cap stocks and corporate bonds

Authorized participants (APs), or financial institutions, manage liquidity in an ETF by “creating” or “redeeming” its shares, which they do by buying or selling the underlying securities and grouping them in baskets to suit the ETF’s structure. These baskets are carefully designed by the ETFs to ensure that ETF shares are liquid. The authors found evidence to support their research model that ETFs dynamically adjust their baskets and portfolios to create liquidity and maintain a balance between tracking the index and keeping the ETF shares liquid.

With those adjustments, ETFs “deviate substantially” from their underlying index, and “despite their passive image, ETFs are remarkably active in their portfolio management,” the researchers write. The implication of that is when ETF investors weigh their returns, they will face “tracking errors,” or differences between the returns of their ETF and those of the stated underlying indices.

Be careful out there.