Passive Investing

What is 'Passive Investing'

Passive investing is an investment strategy that aims to maximize returns over the long run by keeping buying and selling to a minimum. The idea is to avoid fees and the drag on performance that frequent trading can potentially cause.

Traditionally, passive investors have attempted to replicate market performance by constructing well-diversified portfolios, a process that can require extensive research. With the introduction of index funds in the 1970s, achieving returns in line with the market became much easier. In the 1990s, exchange-traded funds (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.

BREAKING DOWN 'Passive Investing'

Also known as a buy-and-hold strategy, passive investors buy a security with the intention of holding it for years or even decades. Unlike active traders, they are not attempting to profit from short-term price fluctuations. In other words, they are not "timing the market." Nor, at least in the case of index investing, are they trying to beat the market.

Now that mutual and exchange-traded funds allow for index investing with comparatively little initial research, the most difficult skill for passive investors to master is arguably emotional control. Resisting the urge to sell when the market experiences a downturn, for example, requires patience and a strong stomach.

On the other hand, research is still necessary even for passive ETF investors. Some funds charge higher fees than others, for example, and not all funds are equally liquid and well-diversified.

Nor is it known how ETFs will fare in the event of a crisis. Prior to the financial crisis, ETFs were relatively niche products. But on August 24, 2015, Credit Suisse estimated that 42% of the dollar value traded on U.S. exchanges was in ETFs. On that date, a rapid sell-off triggered circuit breakers that halted trading. SPY fell 8% intraday and closed down 6%, but others, such as the iShares Core S&P 500 ETF (IVV), were walloped by the sudden scarcity of pricing information. IVV fell 26% intraday and closed down 4%. The S&P 500, the index both funds track, only fell 5% intraday, showing that some ETFs may be better-suited to downturns than others.

Testing Passive Investing

The most vocal defendant of passive investing is probably value investor Warren Buffett. His approach as Chairman and CEO of Berkshire Hathaway Inc. (BRK-ABRK-B) exemplifies some of the principles of passive management, including ultra-long investment horizons (Buffett said in 1989 his "favorite holding period is forever") and very infrequent selling. In a sense, however, he is an active investor. Berkshire does not attempt to replicate market returns through a diversified portfolio, but invests in companies based on particular competitive advantages. In other words, the firm has tried to beat the market and succeeded.

Despite his own success as a quasi-active manager, Buffett is a big proponent of index investing. He has even instructed his heirs to put his estate in index funds. To prove the superiority of passive management, Buffett challenged the hedge fund industry – the quintessential active investors – to a 10-year contest. He put a million dollars in Vanguard's S&P 500 Admiral Fund, the first index fund available to retail investors, while Protégé Partners LLC, the hedge fund that took him up on his challenge, picked five funds of funds.

The wager began in 2008, and the hedge fund industry lived up to its reputation as a way to hedge against losses. Buffett's fund lost 37%, while Protégé's lost 24%. Through 2015, however, Buffett's passive bet has pulled way ahead, with a 66% cumulative return compared to Protégé's 22%.

There will always be defenders of active management who attempt to beat the market, and there will always be those – Buffett among them – who succeed. For proponents of passive management, though, the evidence shows that the average investor is better off putting money in an index fund and leaving it be.

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