Passive investing is an investment strategy aimed at maximizing returns by minimizing buying and selling. The index invests in a common passive investment strategy whereby investors buy a representative benchmark, such as the S&P 500, and hold it for a long time.
Passive investing can be compared to active investing.
Key points to remember
- Passive investing generally refers to a buy and hold portfolio strategy for long-term investment horizons, with minimal trading in the market.
- Index investing is perhaps the most common form of passive investment, with investors looking to replicate and hold one or more market indices.
- Passive investments are cheaper, less complex and often produce better after-tax results over medium to long term horizons than actively managed portfolios.
Understanding passive investing
Passive investment methods aim to avoid the costs and limited performance that can arise during frequent transactions. Passive investing aims to gradually create wealth. Also known as a buy and hold strategy, passive investing means buying a security to own it for the long term. Unlike active traders, passive investors do not seek to profit from short-term price fluctuations or market synchronization. The underlying assumption of the passive investment strategy is that the market is showing positive returns over time.
Passive managers generally think that it is difficult to overtake the market, so they try to match the performance of the market or the sector. Passive investing attempts to replicate market performance by building well-diversified portfolios of unique stocks, which, if done individually, would require further research. The introduction of index funds in the 1970s made it much easier to obtain market-consistent returns. In the 1990s, exchange traded funds, or ETFs, which track major indices, such as the SPDR S&P 500 ETF (SPY), further simplified the process by allowing investors to trade index funds as if they were actions.
Advantages and disadvantages of passive investment
Maintaining a well-diversified portfolio is important for a successful investment, and passive investing via indexing is a great way to achieve diversification. Index funds widely spread the risk by holding all or a representative sample of the securities in their target benchmarks. Index funds follow a benchmark or target index rather than looking for winners, so they constantly avoid buying and selling securities. As a result, their operating costs and expenses are lower than those of actively managed funds. An index fund offers simplicity as an easy way to invest in a chosen market as it seeks to track an index. There is no need to select and monitor individual managers or choose from investment themes.
However, passive investment is subject to total market risk. Index funds follow the whole market, so when the overall stock market or bond prices go down, index funds do too. Another risk is the lack of flexibility. Index fund managers are generally prohibited from using defensive measures such as reducing a position in stocks, even if the manager believes the stock price will fall. Passively managed index funds face performance constraints as they are designed to provide returns that closely follow their benchmark, rather than seeking outperformance. They rarely beat the performance of the index and generally return a little less because of the fund’s operating costs.
Some of the main benefits of passive investing are:
- Ultra low fees: No one selects actions, so monitoring is much less costly. Passive funds follow the index they use as a benchmark.
- Transparency: It is always clear what assets are in an index fund.
- Tax efficiency: Their buying and holding strategy does not usually translate into a massive capital gains tax for the year.
- Simplicity: Having an index or group of indices is much easier to implement and understand than a dynamic strategy that requires constant research and adjustment.
Supporters of active investing would say that passive strategies have these weaknesses:
- Too limited: Passive funds are limited to a specific index or a predetermined set of investments with little or no deviation; thus, investors are locked into these assets no matter what is going on in the market.
- Smaller potential returns: By definition, passive funds will hardly ever beat the market, even in turbulent times, because their core holdings are locked to keep up with the market. Sometimes a passive fund can beat the market a little, but it will never produce the big returns that active managers are looking for, unless the market itself is booming. Active managers, on the other hand, can bring larger rewards (see below), although these rewards also carry higher risk.
Advantages and limitations
To contrast the advantages and disadvantages of passive investment, active investment also has its advantages and limits to consider:
- Flexibility: Active managers are not required to follow a specific index. They can buy stocks of “rough diamonds” they believe they have found.
- Blanket: Active managers can also hedge their bets using various techniques such as short selling or put options, and they can exit specific stocks or sectors when the risks become too great. Passive managers are stuck with the stocks that the index they hold, regardless of their performance.
- Tax management: While this strategy could trigger a capital gains tax, advisers can tailor tax management strategies to individual investors, for example by selling investments that lose money to offset the taxes of the big winners.
But active strategies have these flaws:
- Very expensive: Thomson Reuters Lipper fixes the average expense ratio at 1.4% for an actively managed equity fund, compared to only 0.6% for the average passive equity fund. The fees are higher because all of this active buying and selling triggers transaction costs, not to mention that you pay the salaries of the team of analysts who are looking for stock choices. All of these fees over decades of investment can kill returns.
- Active risk: Active managers are free to buy any investment that they believe brings high returns, which is great when analysts are right but terrible when they are wrong.
- Poor history: The data show that very few actively managed portfolios exceed their passive benchmarks, especially after taking into account taxes and fees. Indeed, in the medium and long term, only a small handful of actively managed mutual funds exceed their benchmarks.