A passive investment strategy involves investing in various asset classes and sectors and accepting their returns without trying to generate the excess return or "alpha" that is the objective of active investing. A passive strategy therefore eschews attempting to identify undervalued securities or timing the market; rather, it involves investing in securities that track various market indexes and benchmarks.
A buy-and-hold strategy is the quintessential passive investment strategy, and involves holding securities for long periods of time that can span decades. This enables the long-term buy-and-hold investor to ride out bouts of market volatility, which can sometimes be severe enough to scare the most seasoned investors. For instance, the S&P 500 plunged 55% in a period of just over 18 months, from November 2007 to the first week of March 2009, during the global credit crisis. It also plummeted almost 48% in the 2½-year "tech wreck" that commenced in March 2000. But despite these massive corrections and other severe bear markets in the 1970s and 1980s, the S&P 500 generated annual returns of 12.1% in the 40-year period from 1975 to mid-2015.
So how does one create a passive buy-and-hold strategy? Exchange-traded funds (ETFs) are the ideal vehicle for such a strategy, because of their liquidity, close tracking of indexes and benchmarks, low management fees, and the wide range of ETFs available. We outline below the steps involved in creating a passive buy-and-hold strategy.
- Evaluate your investment objectives, horizon, and risk tolerance: Do you need access to your investment funds in a year's time to buy a house? Or are you intent on socking away a little bit on a regular basis to build up a retirement nest egg? Your investment objectives, horizon, and risk tolerance are defined by many factors including the stage of the lifecycle you are at, your risk appetite, preference for growth vs. capital preservation, etc. Let's say you are a US-based investor aged 35 who is interested in building up a long-term retirement portfolio. Your objectives are growth and income, and your risk appetite is moderate.
- Identify your asset allocation and asset classes: Asset allocation refers to the proportion of equities, bonds, and cash in a portfolio. Assume you go with 70% equities and 30% bonds. In order to construct a well-diversified portfolio with good growth potential, you decide on the following asset classes: 30% large-cap US stocks, 15% small-cap US stocks, 15% international stocks, 10% real estate investment trusts (REITs), plus 15% US Treasuries and 15% US corporate bonds.
- Allocate your investment capital to the selected asset classes: The advantage of ETFs is that you can construct the above portfolio regardless of the amount of investment capital you possess, whether it is $5,000 or $50,000 or $500,000. Assuming your initial investment capital is $50,000, all you need to do is select one of the many ETFs that follow your specified index or benchmark, as for instance, the SPDR S&P 500 ETF (SPY) for the US large-cap component and an ETF that tracks the Russell 2000 Index for the US small-cap component. You would, therefore, allocate $15,000 to the SPY ETF, $7,500 to the Russell 2000 ETF, and so on.
- Invest regularly and rebalance annually: Since you want to have an adequate amount of funds at your desired retirement age of 65, you add $2,000 to your portfolio at the end of each calendar quarter, allocating funds to each asset class in the same proportion as you had at the start. At the beginning of each year, you evaluate your asset allocation, since the amount allocated to each asset class would have deviated from your target allocation depending on the relative performance of the asset classes. You then rebalance the portfolio to bring it in line with your target allocation. For example, if the Russell 2000 has had a great year and the US small-cap component of your portfolio has grown to reach 20%, you would trim your Russell 2000 ETF holdings so as to bring the allocation down to 15%, and reallocate the excess cash to an asset class whose weight in the portfolio has fallen below your target allocation. Of course, as you grow older, you may change your asset allocation to bring it in line with your new risk tolerance, investment objectives, and horizon.
The Bottom Line
If your portfolio can generate 8% annually in total returns over the 30-year period, you would have a retirement fund of $1.4 million at age 65 (based on an initial investment of $50,000 and annual contributions of $8,000). A 6% annual rate of return would result in a portfolio value of about $920,000 at retirement. A passive buy-and-hold strategy using ETFs is one of the most efficient ways of building such a portfolio, since management fees on most ETFs are generally quite low, while the buy-and-hold strategy results in much lower transaction costs and taxes compared with an active portfolio because of the lack of trading activity.