What is Passive Investing?

Passive investing is an investment strategy to maximize returns by reducing buying and selling. Index investing is one common passive investing strategy whereby investors buy a representative benchmark, such as the S&P 500 index, and hold it over a long time horizon.

Understanding Passive Investing

Passive investing strategies aim to avoid the fees and limited performance that may accompany frequent trading. Passive investing’s objective is to grow wealth gradually. Also known as a buy-and-hold strategy, passive investing means buying a security to own it long-term. Unlike active investors, passive investors do not seek to profit from short-term price fluctuations or market timing. The underlying belief of passive investment strategy is that the market posts favorable returns with time.

Passive managers typically believe it is hard to out-think the market, so they try to match market or sector performance. Passive investing tries to replicate market performance by building well-diversified portfolios of single stocks, which if done individually, would require substantial research. The introduction of index funds in the 1970s made achieving returns in line with the market a lot easier. In the 1990s, exchange-traded funds, or ETFs, that track major indices, such as the SPDR S&P 500 ETF (SPY), simplified the process even further by allowing investors to trade index funds as though they were stocks.

Passive Investing Benefits and Drawbacks

Maintaining a well-diversified portfolio is essential to successful investing, and passive investing through indexing is an excellent way to achieve diversification. Index funds spread risk broadly in holding all, or a representative sample of the securities in their target benchmarks. Index funds track a target benchmark or index rather than seeking winners, so they avoid constantly buying and selling securities. Therefore, they have lower fees and operating expenses than actively managed funds. An index fund provides simplicity as an easy way to invest in a chosen market because it seeks to track an index. There is no need to choose and monitor individual managers, or choose among investment themes.

Nevertheless, passive investing is subject to total market risk. Index funds track the whole market, so when the overall stock market or bond prices fall, so do index funds. Another risk is the lack of flexibility. Index fund managers generally are restricted from utilizing defensive measures such as lowering a position in shares, even if the manager thinks share prices will decline. Passively managed index funds encounter performance constraints as they are designed to offer returns that closely monitor their benchmark index, as opposed to seek outperformance. They hardly ever beat the return on the index, and usually return slightly less because of fund operating expenses.

Some of the key advantages of passive investing are:

  • Ultra-low fees: There’s no one choosing stocks, so oversight is much less expensive. Passive funds abide by the index they use as their benchmark.
  • Transparency: It’s always clear which assets are in an index fund.
  • Tax efficiency: Their buy-and-hold strategy doesn’t usually lead to a massive capital gains tax for the year.
  • Simplicity: Having an index, or group of indices is much easier to implement and comprehend than a dynamic strategy that requires constant research and modification.
  • Proponents of active investing would say that passive strategies have these disadvantages:
  • Too limited: Passive funds are limited to a particular index or predetermined set of investments with little to no variance; therefore, investors are locked into those holdings, regardless of what happens in the market.
  • Smaller potential returns: By definition, passive funds will pretty much never beat the market, even during times of turmoil, as their core holdings are locked in to track the market. In some cases, a passive fund may beat the market by a little, but it will never post the large returns active managers crave unless the market itself booms. Active managers, on the other hand, can bring larger rewards (see below), although those rewards come with higher risk as well.

Benefits and Limitations

To contrast the advantages and disadvantages of passive investing, active investing also have its advantages and constraints to take into consideration:

  • Flexibility: Active managers aren’t required to adhere to a specific index. They can purchase those “diamond in the rough” stocks they think they’ve discovered.
  • Hedging: Active managers can also hedge their bets using different strategies such as short sales or put options, and they’re able to exit specific stocks or sectors when the risks become too big. Passive managers are stuck with the stocks that the index they track holds, regardless of how they are doing.
  • Tax management: Although this strategy could trigger a capital gains tax, advisors can customize tax management strategies to individual investors, such as by selling investments that are losing money to offset the taxes on the big winners.

However active strategies have these drawbacks:

  • Very expensive: Thomson Reuters Lipper pegs the average expense ratio at 1.4 percent for an actively managed equity fund, compared to just 0.6 percent for the average passive equity fund. Fees are higher because all that active buying and selling triggers transaction costs, not to mention that you’re paying the wages of the analyst team researching equity choices. All those fees over years of investing can kill returns.
  • Active risk: Active managers are free to buy any investment they believe would bring high returns, which is great when the analysts are right but terrible when they’re wrong.
  • Poor track record: The data shows that very few actively managed portfolios beat their passive benchmarks, especially after taxes and fees are accounted for. Indeed, over medium to long time frames, only a small number of actively managed mutual funds exceed their benchmark index.

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