“Active” and “passive” are terms that get thrown around a lot when describing investment strategies. But these are binary labels that fail to account for any nuance. Some passively managed index-tracking exchange-traded funds are very active in the risk/reward trade-offs they provide, while some actively managed ETFs don’t differ that much from a broad-market index.
One is not superior to the other. Both can be executed well, or poorly. The investment process and the people behind the process are important no matter if a strategy is active or passive. In fact, they’re about to become even more important when differentiating one ETF from another.
Early Days
Actively managed mutual funds were the only option available to investors just a few decades ago. Their lofty price tags proved a big disadvantage when passively managed mutual funds emerged in the early 1970s. Passive funds charged considerably less because they didn’t need to employ several managers and dozens of analysts to evaluate stocks or bonds and construct portfolios. Instead, they simply owned shares of an index’s underlying companies in the correct proportions.
Investment approaches have diverged since then, with high-fee active managers and low-cost index funds among investors’ primary choices. Many of those early index funds also sought to replicate the S&P 500, and they eventually paved the way for much broader total stock market funds that held shares from every publicly traded company. They were incrementally more passive than the S&P 500 because they owned more of the market.
ETFs like Vanguard Total Stock Market ETF VTI and iShares Core MSCI Total International Stock ETF IXUS are two great examples of broad ETFs that are about as passive as they come. Vanguard Total World Stock ETF VT goes a step further and holds shares of nearly all publicly traded stocks in the world. It is one of the most passive ETFs currently available.
Those index funds and their ETF equivalents proved successful. Over the years, investors parked hundreds of billions of dollars in them because they performed well and beat many of their actively managed peers over long periods. But they didn’t beat every active manager. Some still beat the market despite charging higher fees.
Substance or Hype
Indexes evolved from benchmarks into investments by the late 1990s and early 2000s. Now, instead of being used to grade active managers, investors could invest in a variety of benchmarks for a low cost. That was an attractive proposition because many active managers underperformed their benchmarks.
Once indexes were accepted as investable, they kept evolving to become more different from the market, with some aiming to beat it. Possible outperformance of these “strategic-beta ETFs” was a compelling story and allowed asset managers to justify incrementally higher fees than broad index funds. Higher fees mean greater profits for asset managers. They needed novel investments to sell, and this new breed of strategic-beta ETFs was a great fit. They cost a lot less to manage than active funds.
Furthermore, the risk factors that strategic-beta ETFs were built around had been well accepted by investors and researchers alike. There was plenty of evidence that factors like value and small size had not only outperformed the broader market but also explained a lot of the outperformance that active managers were delivering.
The idea behind strategic-beta indexes, and the ETFs that tracked them, was to exploit the main driver of active managers’ outperformance at a much lower cost. From that perspective, they sit at the intersection of active and passive ETF strategies. They’re active in the risk/reward trade-offs they provide, but they track an index and are passive in their execution.
Did strategic-beta ETFs deliver on that idea?
There’s evidence to suggest that some, though not all, did. Exhibit 1 shows the growth of Schwab Fundamental US Large Company ETF FNDX, which earns a Morningstar Medalist Rating of Silver, and Dodge & Cox Stock DODGX, which is rated Gold, relative to VTI over the 10 years through September 2025. Neither one is labeled here—and that’s the point. It’s difficult to tell which is which. They traveled eerily similar paths and ended up in almost the same place despite radical differences in their underlying investment processes. But there’s a common connection: Both have value-oriented portfolios that also prioritize well-run businesses. That likely explains why historical performance looks so similar.
Admittedly, that example was handpicked, and it isn’t representative of all strategic-beta ETFs. It was meant to show that the risk/reward profile of a highly rated actively managed fund could be closely replicated by a low-cost strategic-beta ETF. Whether that will continue is a different question. It’s unlikely that anyone could identify that outcome in advance, and it doesn’t mean that the risk/reward of other strategic-beta funds should align with their actively managed counterparts.
Some strategic-beta ETFs are more hype than substance. For example, iShares MSCI USA Value Factor ETF VLUE tries to enhance its exposure to cheaper stocks while controlling certain risks. It incorporates an uncommon valuation ratio: enterprise value/operating cash, which is a metric that can be used to value privately held firms without a market price. It also pegs sector weightings to the broader market so that it doesn’t incur any of the riskier sector biases that are typical among value-oriented ETFs. Finally, it holds only around 150 stocks and takes valuations into account when determining position weightings.
Yet, with those considerations, it hasn’t really differentiated itself from a broad value benchmark like the Russell 1000 Value Index. Exhibit 2 shows the growth of VLUE and Vanguard Russell 1000 Value ETF VONV relative to VTI. Like Exhibit 1, the two lines aren’t labeled, and it’s still hard to tell which is which. An investor’s experience with either one was very similar outside of a brief two-year period between July 2017 and June 2019. Each one took turns out- and underperforming the other, until they ultimately ended up in roughly the same place.
Investor interest in ETFs focused on a single risk factor, like FNDX and VLUE, eventually fell flat. So, strategic-beta ETFs evolved further. Asset managers turned to novel and more complicated indexes that claimed to deliver several different risk factor exposures in the same ETF.
These multifactor ETFs also overpromised and underdelivered. They attempted to offer an incremental level of diversification by spreading their bets across several risk factors. In theory, if one or two risk factors lagged, the others could pick up the slack.
That sounds like a great idea. However, many multifactor ETFs ended up prioritizing one or two risk factors over the others, and many wound up performing a lot like value-oriented ETFs. That isn’t such a bad idea, but they didn’t really deliver as advertised. Some were modestly successful at attracting investors, but they didn’t explode in popularity.
The Final Frontier
There is an important lesson to take from the evolution of strategic-beta ETFs: The investment process and the people behind it matter a great deal, and they’re only going to become more important as ETFs continue to grow. Actively managed ETFs stepped in to take their place as fees have come down, and tax efficiency now matches that of index ETFs. Investors have taken notice, and the number of active ETFs should only increase.
New regulations are only promoting the growth of actively managed ETFs. The Securities and Exchange Commission notified Dimensional on Sept. 29, 2025, that it intended to approve its application for exchange-traded share classes of its existing mutual funds. When approved, Dimensional’s mutual funds will be allowed to bolt an ETF onto its existing mutual funds. That creates a new ETF and provides those mutual funds with a big benefit. The ETF’s tax-efficient in-kind transactions can extend to all the stocks and bonds owned by mutual fund share classes. In other words, the entire mutual fund could eventually become as tax-efficient as a stand-alone ETF.
That’s a huge advantage, because a lot of mutual funds have been forced to make capital gains distributions over the past several years as investors leave them for more tax-efficient ETFs. Dozens of other asset managers have filed similar requests with the SEC, and more approvals are likely. There are still some problems to sort out in the background, so there won’t be a tidal wave of these ETFs in the near future. But they’re coming.
Fees for actively managed mutual funds have come down over the past several decades, and an ETF share class could help ratchet them even lower. More importantly, actively managed mutual funds that get an ETF share class will become more tax-efficient, so they’ll be closer to ETFs of all types in that regard. As an ETF’s fee and tax advantage is slowly ported to mutual funds, the investment process and the people behind it will only become more important in differentiating ETFs from each other, regardless of whether they’re labeled active or passive.