Passive Investing

What Is Passive Investing?

Passive investing is an investment strategy that seeks to track the performance of a market index, such as the stock market indices S&P 500 or the Dow Jones Industrial Average. Passive investing differs from active management, in which professional portfolio managers seek to outperform a specific benchmark by buying and selling specific securities and other strategies. Two of the more popular avenues of this style of investing are mutual funds and exchange-traded funds (ETFs).

The concept was popularised by John Bogle. He founded Vanguard Group in 1974 on the belief that most professional investment managers could not outperform the major market averages so investors were wasting their money in paying them to try.

At the time of Bogle's death in January 2019, Vanguard had grown into a giant mutual fund company with US$4.9 trillion in assets under management. Since then, the amount of assets under passive management has grown to surpass those that are actively managed.^[1] The company's flagship fund, the Vanguard 500 Index Fund, was the first index fund for individual investors.^[2]

Advantages Of Passive Management

Low Cost

By merely trying to track—but not outperform—a specific index, passive funds avoid the cost of paying high-salaried portfolio managers who in most cases can't beat the index they're trying to outperform. They also avoid the cost associated with frequently buying and selling individual securities. As a result, the fees passive investment funds charge are a tiny fraction of what active funds charge.

Better Returns

Because passive funds charge lower fees, they can often provide better returns to their investors. At the same time, many studies over the years have shown that most investment managers fail to outperform the indexes they are trying to beat. Passive funds, by contrast, don't pretend they are trying to beat an index, only match it, minus whatever fees they charge.

Simplicity And Transparency

Many if not most passive funds have a simple goal: tracking as closely as possible the returns on a well-known or well-defined index, such as the S&P 500 or the price of a commodity, which investors can easily track themselves on their own.

Lower Risk

Because passive funds track a specific index, investors know what they are buying. The managers of passive funds have no discretion on what stocks or bonds they can buy. They can only buy the securities that are in the underlying index. They are not permitted to try to boost returns by buying something outside their mandate. Active managers, by contrast, can take outsize bets on specific securities they believe will boost returns. They can also borrow money and buy options to try to maximise returns, but those tactics carry increased risk.

Diversification

By tracking a specific index, especially a broad one, investments in a passive fund are automatically diversified among a large number of securities, namely the securities in the index.

Tax Advantages

Because passive funds generally buy and hold the securities they own for long periods, they largely avoid taxes on short-term capital gains, which reduce returns. By contrast, active funds, as the name implies, buy and sell securities all the time, often making short-term profits, which are often taxed at rates higher than long-term gains.

Disadvantages Of Passive Management

Can't Beat The Market

By definition, passive funds will never beat the index they seek to mimic. And while most active managers don't either, there are some "superstar" managers who consistently do this. Passive investors miss out on those opportunities, but they also don't take the risk or bear the expenses of trying.

Market Risk

By contrast, passive investing is subject to market risk. Passive funds are mandated to track a specific index, so they have no discretion in buying securities outside it. This means that they miss out on potential opportunities. Likewise, they have no discretion in selling securities that are part of the index they track, even if they firmly believe they are about to decline in price. Active managers can sell their holdings if they believe it's wise.

Tax Management

While active managers are more likely to trigger taxes on their capital gains, they also have discretion to sell their losers, which can offset capital gains taxes. Passive managers don't have that ability.

Long-term Investment Horizon

Because of their buy-and-hold investment philosophy, passive funds are generally not suitable for investors who have a short-term horizon and are looking to make quick profits. Passive investing is predicated on the idea that over the long-term stocks beat just about any other investment, but only over the long-term. Passive investors also avoid trying to time the market.

Summary

Passive investing seeks to track the return of a market index, such as the S&P 500. Active investing, by contrast, seeks to outperform its benchmarks. Passive investing through mutual funds and ETFs has grown in popularity over the past several decades due to their low fees and because most active fund managers historically fail to outperform their benchmarks.