Updated: Sep 21, 2020
What does “Passive” Investing mean?
Does it invoke a sense of weariness, apathy or indifference? Undesirable qualities in income generation. In the financial language, passive investing describes the novel idea of investing in Market Index or index-tracking Exchange Traded Funds (ETF)s.
Passive investing, in a nutshell, is a method that removes human biases and fallacies from the asset selection and timing process.
“Active” investing requires individuals to pool capital and entrust it to a dedicated fund manager that proactively selects investments and time the entries / exits of financial instruments based on market knowledge, insights from research, professional experience and perceptions or intuition. “Passive” investing tracks a benchmark index and that determines the constituents of the fund. This means investors are aiming to buy and “own” the market, rather than striving to “beat” it.
Most ETFs are considered passive while most mutual funds (or unit trusts) are actively managed, but there are exceptions to this rule.
In the concept of “Passive” investments, investors own a small portion of a variety of assets in a benchmark Index, in proportion to its size (or market capitalization). The index fund does not try to anticipate which stock will perform well, but instead invests in all of them, with funds distributed to the relative size of the stocks in the segment, index or benchmark. No additional strategy will be implemented to generate excess returns above the Index or benchmark returns. These people seek to match the index as they believe that it is unlikely or improbable to “beat” market performance on a regular basis. Passive funds therefore have lower fees and expenses.
“Active” fund managers, however, consider themselves competent to outperform the market by selecting the superior assets and eluding the inferior. They expose the fund to different sectors that the index and make decisions based on market forecasts and outlook. Active funds are therefore more flexible and diversified.
In active investing, these portfolio managers charge remunerations for their effort and they also incur large transaction costs buying and selling stocks as they bid to outperform. Even after these fees and expenses, studies suggest that majority of these funds would still trail the market over the long haul.
Passive investment, in contrast, captures the market’s return at the lowest possible cost, and manage to outperform most active managers over the longer time period. Other than equity indexes, Passive investing can also be applied to other assets such as corporate high-yield bonds and agricultural commodities.
So, how does an investor decide whether to go passive or active? The investor needs to decide primarily on the asset class allocation in the portfolio, depending on the specific risk and return appetite of the individual. Selecting the individual security is considered secondary. Passive investing serves this purpose by making decisions on asset class allocation, without focussing on individual security selection. Passive investing is also less volatile, since they mimic the benchmark.
In summary, there is nothing passive about “passive” investing. Many of the most important choices remain, for example, allocation of asset classes and financial instruments, and selecting the best passive vehicle for investment goal.
There are arguments in favour of Active investing, stating that is some value that expertise in fund management can generate outperformance in markets that are illiquid and non-transparent, for example fixed income securities that do not trade in central exchanges, resulting in lack of central pricing mechanisms, especially for cases of municipal bonds and floating rate securities. Active managers can avoid the neutral value weighting mechanism in fixed income securities where higher value bonds receive higher index weightage, by using fundamental analysis to select higher quality instruments. Some would also argue that Passive investments suffer from tracking error, whether the fund could not mirror the benchmark perfectly.
These arguments are the exception. Passive investing could still capture the market returns in a cost effective and efficient way, in comparison to Active management, which may over perform some years but fall short in others, giving inconsistent results. Active management would be good for shorter time frames.
Finally, personal financial decisions for the individual will depend on one’s risk and return appetite and investment objectives. More risk-averse investors and those in a longer time horizon tend to prefer Index funds where shorter term fluctuations will not be applicable. It is prudent to consult a financial professional before making any investment decision.