Common mistakes about ETFs and passive investing

The common belief: An ETF and an index mutual fund are the same product; one simply trades intraday.

What the data shows: The two differ in their plumbing. Mutual funds transact once a day at net asset value directly with the fund; ETFs trade intraday on an exchange and create or redeem shares in large blocks through authorized participants, usually in-kind. That in-kind mechanism is why ETFs are typically more tax-efficient, and why their intraday price can sit slightly above or below the value of their holdings. The wrapper, not the index, drives most practical differences.

→ Full breakdown: How do ETFs differ mechanically from mutual funds?

The common belief: Holding a 500-stock index removes single-name risk by spreading exposure across hundreds of companies.

What the data shows: The number of holdings is not the same as effective diversification. Cap weighting concentrates the index in its largest names: the top 10 S&P 500 stocks reached roughly 40% of index weight at the end of 2025 (RBC Wealth Management/FactSet), up from about 19% a decade earlier. Long-run returns are more skewed still — Bessembinder (2018) found the best-performing 4% of US listed companies account for the entire net wealth created above Treasury bills since 1926. A broad index spreads names, not necessarily risk.

→ Fuller explanation: Why do a few stocks dominate index returns?

The common belief: A thinly traded ETF is illiquid and risky to buy or sell.

What the data shows: An ETF has two layers of liquidity. Secondary-market volume is only the visible one; the deeper layer comes from authorized participants, who can create or redeem shares against the underlying basket. A low-volume ETF holding liquid securities can absorb large orders at tight spreads because APs source liquidity from the underlying. The relevant question is the liquidity of what the ETF holds, not the fund’s own screen volume.

→ Extended explanation: What is an ETF authorized participant?

The common belief: Arbitrage keeps an ETF’s market price glued to the value of its holdings.

What the data shows: The link holds when the underlying trades freely and loosens when it does not. In March 2020, major investment-grade bond ETFs traded at discounts of up to roughly 6% to reported NAV (MSCI, April 2020), because the underlying bonds had largely stopped trading while the ETF kept printing prices. One reading is that the ETF was discovering price faster than a stale NAV. Either way, the peg is conditional on the liquidity of the basket.

→ The complete explanation: Why do ETF prices diverge from NAV during stress?

The common belief: Index funds simply reflect the market; being passive, they cannot influence it.

What the data shows: Index funds now hold roughly 57% of US equity-fund assets (ICI, end-2024, up from 36% in 2016), and passive overtook active across US mutual funds and ETFs in early 2024 (Cerulli). At that scale, the mirror starts shaping its reflection. Cap-weighted indexing is mechanically procyclical: it must buy more of whatever has already risen, which feeds flows into the largest names and tightens the loop between price and weight. The label describes the manager’s discretion, not the portfolio’s behaviour.

→ Full account: Do passive ETFs make markets more fragile?

The common belief: If you pay active fees, you are getting a portfolio that genuinely departs from the benchmark.

What the data shows: Many do not. Using the active-share measure, Cremers and Petajisto (2009) found close to one-third of US active mutual fund assets behaved as “closet indexers” — funds charging active fees while hugging the benchmark. Their work also showed that only the highest-active-share funds tended to beat their index after costs. The fee tells you the price; active share tells you how much of the portfolio that price actually buys.

→ Complete breakdown: Why do active share metrics matter for active managers?

The common belief: A 2x fund delivers double the index’s return whatever the holding period.

What the data shows: The 2x objective applies to daily returns, not cumulative ones. Because the fund rebalances its exposure each day, its multi-day path depends on the sequence of returns — a property called volatility decay. In choppy, sideways markets, a daily-reset leveraged ETF can lose value even when the index ends roughly flat. These are short-horizon trading tools whose long-horizon behaviour diverges from the simple “2x” label.

→ Complete explanation: Why are leveraged ETFs dangerous long-term?

The common belief: Buy an inverse ETF and hold it to protect a portfolio against a decline.

What the data shows: Like leveraged funds, inverse ETFs reset daily, so daily compounding erodes their value across volatile, range-bound periods even if the index falls over the full window. Historically they have tended to decay when held for extended stretches rather than tracking the inverse of the cumulative move. They are calibrated for short tactical use, not as a buy-and-hold insurance position.

→ Detailed explanation: How do inverse ETFs decay over time?

The common belief: Rules-based factor ETFs (value, momentum, quality) systematically outperform a plain index.

What the data shows: Factor premia documented by Fama and French and others are real over long samples but cyclical, with multi-year stretches of underperformance — value, for instance, lagged growth through much of the 2010s. Some “smart beta” products also risk capturing past performance through back-tested rules rather than a durable premium. The premium is conditional and regime-dependent, not a steady alpha.

→ In-depth explanation: Does smart beta really outperform?

The common belief: An index is a passive measurement, so its composition has no market effect.

What the data shows: Index construction generates predictable trades. When a stock is added to or removed from a major index, the funds tracking it must adjust on a known schedule, creating flows that other participants can anticipate. The effect varies over time and has narrowed as indexing has grown, but the mechanism is structural: a benchmark designed to measure the market also moves parts of it.

→ The full explanation: How does index rebalancing create predictable flows?

The common belief: Buying a hot theme through a dedicated ETF lets you ride that theme’s growth.

What the data shows: Launch timing works against the buyer. Ben-David, Franzoni, Kim and Moussawi (Review of Financial Studies, 2023) found specialized ETFs lost about 30% in risk-adjusted terms over their first five years, because they tend to launch near the peak of enthusiasm, when the underlying stocks are already richly valued. The theme can be real while the entry price already discounts too much of it.

→ Full breakdown: Why do thematic ETFs often underperform after launch?