Passive Investing Explained for Dummies

What is passive investing? 

  Passive investing is a long-term investment strategy wherein investors aim to earn maximum returns over a long period of time by buying financial assets and holding them.   

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Passive investing as an investing strategy 

  Passive investing, also occasionally referred to as passive management, is fundamentally an uncomplicated investment strategy, known for its ‘buy and hold’ approach. Put differently, investors who follow a passive investing strategy attempt to maximise their profits by minimising the buying and selling of securities.    Instead of investing in an individual security, passive investors have a diversified investment portfolio by investing in a mix of securities and funds that mirror the major stock indices.  Investors who practise passive investing rely on steady market increases instead of trying to outperform the financial market. Conversely, active investors aim to generate profits from short-term investments, encouraged and inspired by market fluctuations.    Although not actively involved in the buying and selling process, passive investors usually stay in touch with the market, attempting to duplicate market or industry performance by managing well-diversified portfolios. They also observe the volatility in the markets.    Furthermore, passive investors are aware of the effect of fees that may occur with frequent trading transactions. Hence, they invest in low-cost, diversified funds to reduce transaction fees.  In conclusion, the basic assumption of passive investing is that financial markets achieve positive returns over time, allowing passive investors to build their wealth slowly but steadily.    

Types of investments included in passive investment portfolios 

  Typically, passive investment portfolios include three different types of investments, namely index funds, exchange-traded funds (ETFs), and direct equity.   

• Index funds 

An index fund is a type of investment that aims to track or match the performance of a specific financial market index, such as the Standard & Poor’s Index (S&P 500), the Russel 2000 Index, the Dow Jones Industrial Average, or the Nasdaq Composite.    According to Bankrate.com, index fund managers mimic the index, creating a fund that looks as much as possible like the index, without actively managing the fund. Over time, the index changes, as companies are added and removed, and the fund manager mechanically replicates those changes in the fund.’ (Accentuation in the quotation by the article writer.)    Hence, as the index fund tracks the performance of a particular market index, there is no fund manager required to actively manage an index fund. Therefore, the performance of the fund is based on the price fluctuations of the securities within the fund itself.     There are also fees involved in index funds, although considerably lower than the fees associated with actively managed funds.    The first passive index fund was introduced in 1976 when Vanguard’s 500 Index Fund was launched by the index fund pioneer, John Bogle (1929 - 2019), an investor and business magnate from the USA. He was also the founder and chief executive officer (CEO) of the Vanguard Group.   

• Exchange-traded funds (ETFs) 

A passive ETF tracks a specific index, which can be a broad-based stock market index, an industry (sector) index, or custom-built indices, to name a few options.     Passive ETFs can either totally mirror and index by buying all the securities which is part of the index, or they can be enhanced by purchasing the securities in a particular index that is most representative of the index based on performance, risk, and exposure.     ETFs are similar to index funds. However, the difference is that ETFs enable investors to trade index funds on stock exchanges as though they were stocks.     ETFs were first developed in the early 1990s, and the first ETF listing in the USA was in 1993. Currently, they are listed on stock exchanges all over the world.    The following three ETFs are examples of popular and well-known ETFs:    1. SPDR S&P 500 ETF Trust  This ETF was founded in 1993, making it the ‘grand daddy of ETFs,’ according to Bankrate.com.  It is a broadly diversified index fund which tracks the S&P 500.    2. Shelton Nasdaq-100 Index Direct ETF  The Shelton Nasdaq-100 Index Direct ETF tracks the performance of the largest non-financial companies in the Nasdaq-100 Index, which comprises mainly tech companies.    3. iShares Core S&P 500 ETF  The iShares Core S&P 500 ETF is sponsored by BlackRock, one of the largest fund companies in the world.  It tracks the S&P 500 and was introduced in 2000.  Keep in mind, most, but not all, ETFs are passive funds. Numerous ETFs are actively managed, where fund managers follow a variety of strategies.      

• Direct equity 

Direct equity is a type of passive investment strategy where an investor buys stocks in an index ‘to the same proportion of the index, such as Dow Jones, NASDAQ, etc. Hence, the returns of the investor would mirror the returns of the index of the economy,’ according to WallSteetMojo.  In this instance, the investor would be required to often track the index and make the changes as needed in his/her portfolio.   

Advantages of passive investing 

  Proponents of passive investing indicate, inter alia, the following pros of this trading strategy: 

• Passive investing involves lower trading fees (costs) due to its feature of lower trading transactions, implying that when a market is not active, the fees get reduced.  
• The strategy allows investors to invest in various securities, enabling them to diversify their investment portfolios and to maintain the portfolios. 
• It simplifies investing for investors, especially novice investors, who can buy and keep the securities until the opportunity arises to sell them, generating a profit. 
• Passive investing provides transparency because it is always clear which securities constitute an index fund. 
• According to active/passive barometers, passive investments typically outperform active investments in the long term. It was reported that during the past ten years, only twenty-five percent of active funds outperformed passive funds.   
• Passive investing can reduce investment risk to a certain extent, because an investor invests in a variety of industries and asset classes, contrary to relying on the performance of an individual security. (However, passive investing is subject to total market risk - see disadvantages below). 
• It is a type of investing strategy that needs lower maintenance because an investor is not required to constantly track the performance of his/her investments, reducing the time spent to manage the investment. This is possible because passive investing is a long-term strategy, during which there is no need for an investor to predict winners and losers in a financial market or to select and monitor fund managers.

 

Disadvantages of passive investing 

  Proponents of active investing would mention the following disadvantages, among others, of passive investing: 

• Passive investing is subject to total market risk because they track an entire financial market. Hence, when the overall stock exchange plummets, index funds follow suit. 
• The strategy becomes less enticing if active investments outperform passive investments by yielding better returns. This happens because passive funds will almost never outperform the market, even during periods of price volatility, because the purpose of their core financial assets is to track the market. Occasionally, a passive fund may outperform the market marginally, but it will never generate the favourable returns active funds can produce. Hence, investors are encouraged to invest more in active investment options. 
• Passive investing contains a lack of flexibility, and crucial investment decisions are not under the control and management of the investor. For example, managers of index funds are compelled to follow predefined rules and regulations, prohibiting them from reducing a position in a security, even with the possibility that the security’s price will decline.  
• Passive funds are too limited, implying they are limited to a specific index with little to no variation. Hence, investments of passive investors are tied up, regardless what happens in a specific financial market.  

   

Differences between passive investing and active investing 

  Contrary to passive investing, active investing refers to a type of investment strategy wherein regular buying and selling of financial assets (securities) take place to generate short-term profits. The main object of active investors is to beat a benchmark index.   There are numerous differences between passive and active investing, as indicated in the following list, which does not pretend to be a complete list of all the differences.    

Passive Investing	Active Investing
Long-term investment goals	Aim at short-term and long-term investment goals
Buy and hold financial assets for longer terms	Financial assets are bought and sold frequently
Copy significant market indexes to be at par with the markets	Investors intend to beat the market, generating increased profits
Extremely low fees	Very expensive, due to high transaction fees
Lack of flexibility - passive managers are required to keep the securities that are included in the index they track, notwithstanding how they are performing	Flexible - active managers are not required to follow a specific index, allowing them to choose securities they consider outstanding performers
Low level of risk involved	Active risk involved

 

Choices, choices - passive trading or active trading? 

  Over the years, the proponents of passive investing and the proponents of active investing have continuously debated the pros and cons of the two trading strategies.   Passive management and active management are contradictory investing strategies. If debating this issue, it is important to know that there is no final answer as to which of these strategies is intrinsically better. Instead, investors should consider his/her individual circumstances, determining which strategy is more beneficial for him or her.    It is important to consider the following factors when you make your choice between passive and active trading:   

• Risk tolerance 

Risk tolerance refers to the amount of loss an investor is willing to take while considering which investment to make. There are several factors that determine an investor’s risk tolerance, also referred to as the level of risk, namely: 

1. Personal financial goals 
2. Time period 
3. Size of investment portfolio 
4. Comfort level 
5. Age 

Typically, investors are categorised into three main classes of risk tolerance, based on how much risk they can bear. The three classes are aggressive, moderate, and conservative.  Knowing their risk tolerance enables investors to decide which investing strategy to follow and to plan their entire investment portfolio.   

• Investment goals 

An investor’s investment goals are another key factor that guides an investor to decide which investing strategy to use.  For example, there is a big difference between the investment goal of Cathy, a 27-year-old who intends to buy a home over the next few years, and James, a 27-year-old who saves to retire at 60.  The investment strategies they should follow are significantly different. Cathy, who wants to buy a home as soon as possible, will consider a high-risk, high-return type of investment. Contrarily, James, who has 33 years to retirement, will follow a more conservative passive investing strategy.    

• Transaction fees 

The cost of transactions may also play a role when an investor has to choose between passive and active investing.  Many investment advisors prefer a strategy which is a combination of passive and active management. This approach can help to minimize the risk associated with price volatility on stock exchanges during volatile periods.   The choice between the two strategies does not have to be an either/or choice for investors and investment advisors. In addition, a combination of the two can help to diversify an investment portfolio and to mitigate overall investment risk.    Note: This article does not constitute investment, financial or trading advice. Please obtain the advice of a professional, reputable, and regulated broker before making trading and investment decisions.  

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