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 purchase a representative benchmark, such as the S&P 500 index, and hold it over a long time horizon.

Understanding Passive Investing

Passive investing strategies strive to avoid the fees and limited performance that might accompany regular trading. Passive investing’s goal is to build wealth gradually. Also referred to as a buy-and-hold strategy, passive investing means buying a security to have it long-term. Unlike active investors, passive investors do not seek to profit from short-term price fluctuations or market timing. The underlying assumption of passive investment strategy is that the market posts positive returns with time.

Passive managers generally believe it is difficult to out-think the market, so they try to match market or sector performance. Passive investing attempts to replicate market performance by constructing well-diversified portfolios of single stocks, which if done individually, would require considerable research. The introduction of index funds in the 1970s made attaining returns in line with the market much 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 enabling 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 using 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 as opposed to seeking winners, so they avoid constantly buying and selling securities. Therefore, they have reduced fees and operating expenses than actively managed funds. An index fund provides simplicity as a simple way to invest in a chosen market because it seeks to track an index. There is no need to select and monitor individual managers or choose among investment themes.

However, passive investing is subject to total market risk. Index funds track the whole market, so when the overall stock market or bond prices drop, so do index funds. Another risk is the lack of flexibility. Index fund managers generally are restricted from utilizing protective measures such as reducing a position in shares, even if the manager believes share prices will drop. Passively managed index funds encounter performance constraints as they are designed to provide returns that closely track their benchmark index, instead of seeking outperformance. They hardly ever beat the return on the index and often return slightly less due to funding operating costs.

Some of the key advantages of passive investing are:

  • Ultra-low fees: There’s nobody picking stocks, so oversight is a lot 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 does not usually lead to a substantial capital gains tax for the year.
  • Simplicity: Owning an index, or group of indices is far easier to execute and comprehend than a dynamic strategy that requires continuous research and adjustment.

Proponents of active investing would say that passive strategies have these weaknesses:

  • Too limited: Passive funds are limited to a specific index or predetermined set of investments with little to no variation; therefore, investors are locked into those holdings, regardless of what happens in the market.
  • Smaller potential returns: By definition, passive funds will basically never beat the market, even during times of turmoil, as their core holdings are locked in to track the market. Sometimes, a passive fund might 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 include higher risk as well.

Benefits and Limitations

To contrast the benefits and drawbacks of passive investing, active investing also have its benefits and limitations to take into consideration:

  • Flexibility: Active managers aren’t required to abide by a particular index. They can buy those “diamond in the rough” stocks they believe they’ve found.
  • Hedging: Active managers can also hedge their bets using various 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.

But active strategies have these shortcomings:

  • Very expensive: Thomson Reuters Lipper pegs the average cost ratio at 1.4 percent for an actively managed equity fund, compared to only 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 salaries of the analyst team researching equity choices. All those fees over decades of investing can kill returns.
  • Active risk: Active managers are free to purchase any investment they think would bring high returns, which is great when the analysts are right but terrible when they’re wrong.
  • Poor track record: The data show that very few actively managed portfolios beat their passive benchmarks, particularly after taxes and fees are accounted for. Indeed, over medium to long time frames, just a small handful of actively managed mutual funds surpass their benchmark index.

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