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.

RELATED TERMS
  1. Passive ETF

    One of two types of exchange-traded funds (ETFs) available for ...
  2. Index Investing

    A form of passive investing that aims to generate the same rate ...
  3. Passive Activity Loss Rules

    A set of rules that prohibits using passive losses to offset ...
  4. Passive Income

    Earnings an individual derives from a rental property, limited ...
  5. Passive Activity

    Activity in which the taxpayer did not materially participate ...
  6. Actively Managed ETF

    An exchange-traded fund that has a manager or team making decisions ...
Related Articles
  1. Mutual Funds & ETFs

    Exchange-Traded Funds: Active Vs. Passive Investing

    Although indexing (a passive investment strategy) has been used by institutional investors for many years, it is still relatively new for the typical individual investor. Because ETFs use predominately ...
  2. Mutual Funds & ETFs

    Active Management Case Study: Comparing Index to Actively Managed Fees (MORN)

    Find out how actively managed funds compare with passively managed funds in terms of cost and whether higher cost funds outperform lower cost funds.
  3. Investing Basics

    A Statistical Look at Passive Vs. Active Management

    Find out what the data has to say about the passive management Vs. active management debate, and why there isn't necessarily a clear winner.
  4. Mutual Funds & ETFs

    Passively Managed Vs. Actively Managed Mutual Funds: Which is Better?

    Learn about the differences between actively and passively managed mutual funds, and for which types of investors each management style is best suited.
  5. Retirement

    Active vs. Passive Investing During Retirement

    How these two investing approaches work – and how to decide which best suits your precious nest egg.
  6. Investing News

    Buffett's Bet with the Hedge Funds: Year Eight (BRK-A, BRK-B)

    In 2008, Warren Buffett placed a million-dollar bet that an S&P 500 index fund would beat the funds of funds hedge fund managers would select.
  7. Mutual Funds & ETFs

    Index Mutual Funds Vs. Index ETFs

    When considering an index mutual fund versus the ETF variety, investors should consult an experienced professional.
  8. Trading Strategies

    Active or Passive? How to Blend Aspects of Both

    Investment fund strategies can broadly be divided into either active management or passive management.
  9. Investing

    4 Best Passive Income Investments

    Generating income from passive investments begins with knowing which ones are the best fit for your portfolio.
  10. Investing Basics

    Tops Tips for Trading ETFs

    A look at two different trading strategies for ETFs - one for investors and the other for active traders.
RELATED FAQS
  1. What is the difference between passive and active asset management? (SPY)

    Find out about active asset management, passive asset management, how these strategies are utilized and the differences between ... Read Answer >>
  2. What's the difference between an index fund and an ETF?

    Learn about the difference between an index fund and an exchange-traded fund and how index fund investing compares to value ... Read Answer >>
  3. Does index trading increase market vulnerability?

    Learn how the rise in popularity of passive ETFs and mutual funds tracking indexes has increased the correlation among stocks, ... Read Answer >>
  4. What gives the best results, an index fund or an ETF?

    Investing in ETFs or index funds is a matter of personal choice, but market logic advocates ETFs for rebalancing funds and ... Read Answer >>
  5. What are the disadvantages of an index fund over an actively managed fund?

    Read the advantages an actively managed fund has over its more staid compatriot, the indexed fund, and make your own decision ... Read Answer >>
  6. Are target-date funds (TDFs) actively managed?

    Learn how target date funds (TDFs) can be actively managed or go with a more of a hands-off approach featuring passively ... Read Answer >>
Hot Definitions
  1. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  2. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  3. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  4. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  5. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
  6. Unlevered Beta

    A type of metric that compares the risk of an unlevered company to the risk of the market. The unlevered beta is the beta ...
Trading Center