Passive Investing, The Complete Guide

Passive investing, understanding this investment strategy, how it works, its trend and the benefits to your portfolio

This article will act as a guide to passive investing.

Quick Facts

  • Passive Investing is the opposite to Active Investing.
  • Aims to replicate a specific market or index.
  • Passive investments are also known as Passives, Trackers, Index and Market Funds.
  • Index funds are the most common form of passive investing.
  • They buy & hold for the long term

Introduction

In recent years collective investments have become more and more popular due to the benefits they offer to investors, specifically the pooling of investors money in order to purchase assets and develop a single, large, diversified portfolio. As this market has grown the popularity of multi-asset risk targeted investment funds has also increased.

Collective investment funds can be active or passively managed.

The passive investment management style is often referred to as passives, trackers, index and market funds.

Passive investment has been dubbed as the investment strategy of the Millennial generation.

Rationale for passive investing can seem counterintuitive due to the fact that the concept derives purely from financial economics. Tracking rather than beating the market, keeping costs to a minimum.

What is Passive Investing

Passive investing is an investment strategy that aims to invest over the long term in a simple cost effective method. It aims to avoid fees and limited performance from regular trading and it is contrasted with active investing.

The passive investor aims to build wealth gradually over time.

Market timing or short term price fluctuations are not a consideration with this strategy, as you would expect from its counterpart active investing. The underlying assumption of passive investment strategy is that the market posts positive returns over time. This therefore takes out the need for the active manager looking at short term opportunities.

Passive managers generally believe it to be difficult to out perform the market over time – matching the market is therefore the approach taken. Attempting to beat the market requires a team of professionals and there is no guarantee the manager and team will out perform, but in the meantime they will create costs.

A change in the investment manager will have no impact on its performance due to the systemised approach. 

Typically, a lower turnover of holdings can mean lower transaction costs. Avoiding the fees and limited performance that may occur with frequent trading. It is broadly used as a buy-and-hold portfolio strategy for long-term investment horizons.

Active managers may beat the market during a particular period and this could even be over a few years, the issue that needs to be considered is how long can this be achieved for and was the successful run due to skill rather than luck? And also what does the future hold for that manager?

How do they invest?

A typical fund will buy all of the holdings in a particular index, for example the FTSE 100. This example would represent UK equities (Shares) and the fund would hold the the same proportion of the index – so if HSBC represents (weighted) 5% of the market capitalisation the fund would therefore hold 5% of the HSBC stock.

Active funds will select holdings based on the managers decision and is impacted by their choice when it comes to holding selection.

How to consider volatility, charges and diversification

Volatility for a passive fund will be correlated (matched) with the index itself, so if the index goes up, the valuation will follow, but also the same if the index goes down.

Passive investments typically operate with lower investment charges, unlike active investments which often carry higher charges due to the investment managers’ role.

Diversification can be achieved by adding passive funds from a wide range of asset classes and geographic locations. This will limit an exposure to one type of asset in one location. For example holding a fund that was a UK based FTSE 100 fund would concentrate the investment to UK Equities, demonstrating no diversity in a portfolio.

Looking at the theory

As I said earlier the aim of the strategy is for a long term & lower cost which the theory suggests is better than attempting to outperform the market.

The efficient-market hypothesis substantiates this as the theory supports it is impossible to beat the market over the long term. Further research using the capital asset pricing model (CAPM) also demonstrates the same philosophy.

In the US passive funds often outperform active managers.

Benefits

  • Costs – Passive investment funds have lower charges.
  • Transparency – Holdings within the funds are easier to identify.
  • Tax efficiency – With fewer trading, capital gains tax implications are reduced.
  • Simplicity – fewer funds required for a global spread portfolio.
  • Diversification – Index funds usually hold many more individual shares or bonds than an active portfolio. The more shares or bonds you hold, the lower the impact if any one of them performs poorly.

Downsides

One potential downside of passive investing, is that if an index is dominated by a particular holding. In this scenario if it takes a tumble, the investment will be exposed to this correction.

Potential lower returns – they will not beat the market, because they can’t. Proponents of active investing will say that the method is limited and carries the chance of smaller potential returns. 

What are the investment options

There are a wide range of options available when considering investing. This could be anything from 100% in passive funds all the way down to keeping them out of a portfolio completely. Blending with an active / passive split – can be a good method to start off passive investing, this can be adopted in a core and satellite approach.

Summary

When I consider what my successful investors attitudes are, there are always a couple of stand out traits – patience and repetition.

They will stick to a plan (with reviews and adjustments along the way) and they keep adding to it with either regular payments or lump sums. There is no question that successful investing is a long-term pursuit.

As long as you have the understanding that market corrections and crashes will occur from time to time, keep portfolios diversified, then this method can offer a simple straight forward investment approach. With research continuing to build, it may be the superior way to invest for the future. 

A consideration that all investors should think about for the future of a portfolio.

I’m happy to help you with any questions you have on the passive investment subject.

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