Passive Investing: Pros, Cons, and How it Works

What is passive investing?

Passive investing is an investment strategy you’ll often hear talked about alongside active management. Deciding whether you want to actively or passively invest your funds – or use a mixture of the two strategies – may be one of the first, and most important, decisions you’ll make as an investor.

Passive investment is sometimes characterised as, “If you can’t beat them, join them”. And that’s a pretty fair summary.

With active investing, individual investors will research companies and stocks to choose where to invest their money. The aim is to pick stocks that outperform others and generate gains that beat a certain benchmark. The benchmark is what success is measured against for active managers. UK retail clients often use the FTSE 100 or FTSE All Share as a benchmark to measure how their portfolios are performing, which, if things go well, allows them to say they ‘beat the market’.

Passive investors are not looking to ‘beat the market’. Rather, passive investors aim to follow a stock market, market index or specific area of the stock market and replicate its returns over the long term.

Passive investors see the market as fundamentally efficient and therefore believe there is limited potential for outsmarting it. Crucially, they also see unnecessary risk and cost in trying to do so.

Passive management isn’t about picking hot stocks, market timing, or quick wins; it is a ‘big picture’ approach that looks to build wealth gradually over time. The fundamental assumption is that the market can be trusted to deliver positive returns over long periods.

Key features of passive investing

The key features of passive investing are:

• A belief that markets are efficient and therefore cannot be beaten
• Long-term goals – the mindset that slow and steady wins the race
• A buy-and-hold strategy
• Simplicity – very little research, analysis and trading is necessary
• Low fees

How does passive investing work?

Passive investing was first made available for retail investors in 1976, when Jack Bogle, founder of Vanguard, created the world’s first retail index fund. It tracked the S&P 500 – an index of the 500 largest companies in the US.

Bogle had a motto that encapsulates passive investing nicely: “Don’t look for the needle in the haystack. Just buy the haystack”.

There is very little buying and selling involved with a passive strategy. Instead of hand-picking the individual stocks or bonds that a fund will hold, passive investors will buy all (or a representative sample) of the stocks and bonds in the index being tracked.

The strategy is to mirror the performance of an entire market, index or area of a market and protect investors from human error, which is ultimately always a risk with an actively managed fund.

The FTSE 100 is a commonly tracked UK market. It is an index of the UK’s 100 largest companies based on their market capitalisation. Typically, a passive fund manager will purchase shares in all of the 100 companies listed in the FTSE 100, proportionate to their value in the index. This way, the fund can replicate exactly the performance of the FTSE 100 index over time.

As the composition of the index changes over time, the fund manager will replicate those changes, ensuring returns consistently track the performance of the index over the long term.

Passive returns are dependent on the performance of the index itself. If the benchmark you are tracking falls, so will your fund. If it rises, your fund will rise as well.

These funds are also known as tracker or index funds.

Passive investing strategies

There are several ways to be a passive investor. Two common ways are to buy index funds or Exchange Traded Funds (ETFs). Both are types of mutual funds — investments that use money from investors to buy a range of assets and both are commonly used in passive strategies.

Because index funds and ETFs let you invest in holdings from various industries and asset classes, passive investing can help you diversify, so even if one asset in your basket has a downturn, it shouldn’t affect your entire portfolio.

Index funds

One of the most common strategies used by passive investors is to buy index funds. An index fund is a type of mutual fund that uses money from investors to buy a range of assets and then simply tracks the rise and fall of the assets within the index.

With this strategy, investors spread their money across a large number of stocks in an approach known as diversification. A diversified portfolio aims to lower exposure to the potential losses of any one industry or asset class. It is an insurance measure, allowing poor performance in one area to be offset by the better performance of another.

Index funds can only be bought and sold at set prices after the market closes and the asset value is announced. If you’re investing to meet long-term objectives, this is no issue as slight fluctuations in value at different times of the day are not likely to give you cause for concern when in it for the long haul. If you have an interest in intraday trading, however, ETFs may better suit your needs.

ETFs

Exchange Traded Funds (ETFs) are also popular with passive investors. Similar to index funds, an Exchange Traded Fund is a mutual fund that tracks an index. They differ from index funds in that they require a bit more of a hands-on approach to management. With ETFs, there is no need to wait until the market closes to trade. ETFs can be bought and sold during market hours like stocks and are bought straight from other investors – without the need for the mutual fund company to act as the middleman.

An added benefit of ETFs is that they are often cheaper to buy than index funds.

Pros and Cons of Passive Investing

Pros

The advantages of passive investing are:

• It is one of the easiest ways to gain entry to investing
• Lower costs: Transaction costs for passive investments are usually lower than active funds because a passive fund does not require fund managers to be active in researching and analysing investment opportunities. The difference between an average expense ratio of 0.75% a year for an actively managed fund and the 0.1% per year typically charged by passive index fund managers may appear relatively small but result in a considerable difference to your returns over time.
• Because passive investing follows the performance of a benchmark, the risk of underperforming due to individual fund manager choices that don’t pay off is far lower: Great if you don’t have a high risk tolerance.
• While past performance is not a guarantee of future performance, historical data does suggest that replicating the performance of an index does produce positive returns over time which means this approach is associated with less risk.

Cons

The disadvantages of passive investing are:

• There is no opportunity to outperform the market as passive investments are following a benchmark, not trying to beat it
• A lack of choice: When you decide to track an index, you must accept the holdings in that index, regardless of their quality or characteristics
• Your investment is subject to total market risk: When there is a market downturn, and stock prices fall, so does the value of your investment
• There is no opportunity to put defensive measures in place with passive investing, even if you think share prices will decline.
• There is no allowance for the emotional biases and information failures that most people accept do come into play in pricing. In other words, if you believe the market doesn’t always get it right, you can’t do anything but accept the inevitable mistakes it will make – and which could damage your returns.

What is the evidence for passive investing as a strategy?

According to Kent Smetters, professor of business economics at Wharton, active mutual fund managers’ returns consistently trailed passive funds over a recent 10-year period. “Those very few investment managers that outperformed the passive index were still likely to underperform in the future,” notes Smetters. “In fact, outperformers had only a 20% chance of repeating the following year, and… just a 10% chance of outperforming three years in a row.”

Source: The Wharton School, The University of Pennsylvania

Passive investors tend to believe that active fund managers cannot be relied on to pick enough winners and justify their high fees. And the evidence does show that it is difficult for asset managers to select assets that consistently outperform the market by enough to compensate investors for the high fees they typically need to pay active fund managers.

Morningstar’s active/passive barometer report found passive funds consistently outperforming actively managed ones in the long term. In fact, in the past 10 years, it found only 25% of active funds beat passive funds.

Source: Morningstar

Although passive investments are less able to bring home the market-busting returns that are possible with actively managed funds, they have strong appeal as they allow investors to minimise costs while also tracking the gains of an index fund over time.

Is passive investing right for you?

In recent years, there has been a considerable shift towards passive investing and away from active investing. Low interest rates and economic events have created a tough environment for actively managed funds. Because of this, and the fact that investors are becoming more cost conscious, passive investing has risen in popularity.

But, as with most things in life, what works for one person may not work for another. It is important to consider your appetite for risk and your personal goals before choosing an investment strategy. And it’s wise to consult a financial advisor if you’re unsure whether passive funds or an actively managed equity fund is better suited to your circumstances.

One other important consideration is time: keeping track of and managing investments is a heavy time commitment. Active investors need to dedicate considerably more time to their investment strategies than passive investors. If you want to invest but have limited bandwidth, passive funds may be a good option for you.

Alternatively, consider a combination of both. Passive investing may have the benefits of being low cost and working better for certain objectives but actively managed funds may benefit you in particular investing climates, allowing you to sell stocks when you believe the markets aren’t perfect.

Active investing vs. passive investing

The debate over the relative merits of active and passive investing is one of the most divisive and fiercely contested in the world of investing.

So, what’s the distinction between passive and active investing?

Active investments are funds run by active managers with the aim of outperforming a benchmark index, such as the FTSE 100 or Dow Jones Industrial Average, over time. They engage in frequent trading – buying and selling of the stocks they believe are undervalued or emerging markets which could achieve higher returns than the benchmark index.

When funds actively manage, they also avoid investing in overvalued stocks which could reduce the risk of underperforming the index. Many investors like this approach because it offers the potential for higher returns and allows fund managers to take steps to avoid losses in the face of a market downturn.

Because of the intensive nature of the active approach, actively managed portfolios will incur higher costs, and active trading, detractors believe, bears greater risk.

Passive investments are funds intended to match, not beat, the performance of a benchmark index. There is minimal buying and selling with a passively managed portfolio. Instead, target benchmarks are reached by buying weighted stocks in each of the companies listed in the index. Lower fees and long term growth are prioritised, which means that long-term investors have been increasingly drawn to this approach.

Passive Investing FAQs