Passive investing is an investment strategy to maximize returns by minimizing buying and selling. Index investing in 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.
Passive investing can be contrasted with active investing.
- Passive investing broadly refers to a buy-and-hold portfolio strategy for long-term investment horizons, with minimal trading in the market.
- Index investing is perhaps the most common form of passive investing, whereby investors seek to replicate and hold a broad market index or indices.
- Passive investment is cheaper, less complex, and often produces superior after-tax results over medium to long time horizons than actively managed portfolios.
Understanding Passive Investing
Passive investing methods seek to avoid the fees and limited performance that may occur with frequent trading. Passive investing’s goal is to build wealth gradually. Also known as a buy-and-hold strategy, passive investing means buying a security to own it long-term. Unlike active traders, 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 over 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 extensive research. The introduction of index funds in the 1970s made achieving 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 allowing investors to trade index funds as though they were stocks.
Passive Investing Benefits and Drawbacks
Maintaining a well-diversified portfolio is important to successful investing, and passive investing via 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 rather than seeking winners, so they avoid constantly buying and selling securities. As a result, 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 monitor individual managers, or chose among investment themes.
However, passive investing is subject to total market risk. Index funds track the entire 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 usually are prohibited from using defensive measures such as reducing a position in shares, even if the manager thinks share prices will decline. Passively managed index funds face performance constraints as they are designed to provide returns that closely track their benchmark index, rather than seek outperformance. They rarely beat the return on the index, and usually return slightly less due to fund operating costs.
Some of the key benefits of passive investing are:
- Ultra-low fees: There's nobody picking stocks, so oversight is much 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 typically result in a massive capital gains tax for the year.
- Simplicity: Owning an index, or group of indices is far easier to implement 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 specific index or predetermined set of investments with little to no variance; thus, investors are locked into those holdings, no matter what happens in the market.
- Smaller potential returns: By definition, passive funds will pretty much never beat the market, even during times of turmoil, as their core holdings are locked in to track the market. Sometimes, a passive fund may beat the market by a little, but it will never post the big returns active managers crave 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 pros and cons of passive investing, active investing also have its benefits and limitations to consider:
- Flexibility: Active managers aren't required to follow a specific 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 techniques 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: Even though this strategy could 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 expense 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 picks. All those fees over decades of investing can kill 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, especially 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.