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 occur with frequent trading. Passive investing’s objective is to grow wealth gradually. Also referred to as a buy-and-hold strategy, passive investing means purchasing security to have it long-term. Unlike active traders, 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 positive returns with time.

Passive managers typically think it is hard to out-think the market, so they attempt 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 substantial research. The introduction of index funds in the 1970s made attaining 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 enabling investors to trade index funds as though they were stocks.

Passive Investing Advantages and Drawbacks

Maintaining a well-diversified portfolio is essential to successful investing, and passive investing using indexing is a great 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 offers simplicity as an easy way to invest in a chosen market because it seeks to track an index. There is no need to select and track 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 fall, so do index funds. Another risk is the lack of flexibility. Index fund managers typically are restricted from using protective measures such as reducing a position in shares, even if the manager thinks share prices will drop. Passively managed index funds experience performance restraints as they are designed to offer returns that closely monitor their benchmark index, instead of seeking outperformance. They rarely beat the return on the index, and often return slightly less because of fund operating costs.

A few of the key benefits of passive investing are:

  • Ultra-low fees: There’s no one choosing stocks, so oversight is a lot less expensive. Passive funds follow 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 result in a substantial capital gains tax for the year.
  • Simplicity: Having an index, or group of indices is far easier to execute and comprehend than a dynamic strategy that requires constant research and adjustment.
  • Proponents of active investing would say that passive strategies have these weaknesses:
  • 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 basically never beat the market, even during times of turmoil, as their core holdings are locked in to track the market. Occasionally, a passive fund might beat the market by a little, but it will never post the large returns active managers yearn for unless the market itself booms. Active managers, on the other hand, can bring bigger rewards (see below), although those rewards come with greater 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 follow 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 different strategies such as short sales or put options, and they’re able to exit particular stocks or sectors when the risks become too big. Passive managers are stuck with the stocks that the index they track holds, no matter how they are doing.
  • Tax management: Even though this strategy can trigger a capital gains tax, advisors can tailor 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 wages of the analyst team researching equity choices. All those fees over decades of investing can destroy returns.
  • Active risk: Active managers are free to buy 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, only a small handful of actively managed mutual funds surpass their benchmark index.

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