What is passive investing? The pros & cons of passive investing

Passive investing is an investing strategy focused on buying and holding low-cost index funds/index ETFs or other assets like stocks or real estate for the long term, with little interference in terms of frequent selling or active trading (sometimes called portfolio turnover) in order to minimize trading fees. It is a hands-off approach. It takes comparatively minimal effort and has the potential to produce inflation-beating returns over the long term via compound interest.

There are several forms of passive investing, including buying real estate, owning dividend stocks, buying index funds, or purchasing art. This assumes the buyer isn’t selling the asset soon after they purchased it – that would make them an active investor, the opposite of passive – but rather holding on to the asset for the long term.

John Bogle is often credited with being the father of passive investing. He was the CEO of Vanguard and, in 1976, he launched the first fund that tracked an index, which was available to retail investors. It was called the First Index Investment Trust.

Passive investors hold for the long-term, but how long that is will vary, based on the individual. For some people, the long-term is a few years while, for others, it’s 20 years or more.

The timeframe of the passive investment strategy often depends on how long the investor has until retirement, which is typically when funds start getting withdrawn. For example, for a 20-year-old passive investor, their timeframe to retirement is typically 40 to 45 years. For someone in their fifties, they may only be holding their passive investments for another 10 years.

The goal is to minimise selling then rebuying, which is active investing as it incurs fees which can be seen as a drain on the performance of a portfolio. Passive investors add to positions but rarely close out trades until retirement.

Learn how to invest in ETFs​ using a passive strategy.

Warren Buffett – the famed billionaire long-term investor who is the CEO of Berkshire Hathaway – believes most people should be passive investors in index funds. There are a few reasons for this. Here are some of the benefits:

Looking at past performance, passive investing sounds pretty good. But that’s assuming what happened in the past continues to happen, and even that can be scary at times.

For more than 100 years, despite volatility and bear markets, stock market benchmark indices have tended to rise on average overall. And, depending on the index, the average ranges from a few per cent up to about 10% or 11%. The S&P 500 has averaged 8% since including 500 stocks in the index in 1957.

One isn’t better than another. There are great passive investors and great active investors. But being an active investor requires more work and skill to overcome the additional fees of active trading. The rewards are potentially higher with active investing, and active investors may be able to avoid management fees by doing the work themselves.

Warren Buffett believes most people are better off as passive investors, which allows their money to compound over time. The past performance of index funds indicates this is an acceptable choice. Active investors may be able to compound​ their money quicker, but only if they beat the index funds year in and year out, which is no mean feat as many professional fund managers consistently underperform the index.

It seems many investors are on board with passive investing. In 2019, funds in passive investments surpassed those in actively managed investments. This indicates more people are choosing to passively invest than with active managers and stock pickers.

Whether to invest passively or actively is a personal choice. Here are a few things to consider:

While passive investing generally means buy-and-hold, there are a few different ways this can be accomplished. Here are three passive investing portfolio strategies:

This is one of the most popular passive investing strategies. It involves buying a personally selected group of index funds. These positions may be added via regular contributions to the account, with some investors choosing to automate this in order to make the portfolio growth completely passive. Popular indexes are discussed in the section below and are often used for this strategy.

With this approach, the investor decides how they wish to allocate their account​​. They then buy individual assets, such as stocks, bonds, precious metals, or ETFs. They are using no or few index funds in their portfolio and instead are buying individual stocks and bonds they believe will perform well over the long term. This approach is generally going to be more research-intensive.

This approach involves having a core – or substantial chunk – of capital in diversified index funds. These often include share and bond ETFs. The percentage of the account allocated to index funds is up to the individual. The rest of the funds are used for seeking out higher gains, such as purchasing individual stocks or investing in more niche ETFs. The core makes market average returns, while the smaller niche ETFs or stocks, which are generally more volatile, offer the potential for increased returns, thus potentially increasing the return of the whole portfolio. The non-core positions also have the potential to lose more, reducing overall performance in tough years.

These are some of the most popular ETFs based on their total assets under management. Some of these passive index funds focus on large-cap stocks, while others look at smaller cap stocks​, dividend stocks, foreign stocks, or bonds.

Automating investments will eliminate the work of having to manually invest each time there is a contribution to the account or dividends are received. Automation involves setting up auto deposits into the account, then having those funds applied to the selected investments.

It also involves having dividends automatically reinvested into the index fund that issued them. This allows that money to keep compounding. This is often referred to as a dividend reinvestment program or DRIP program.

Not all the work can be automated, though. Investors still check their investments to make sure they have the desired portfolio allocation over time. This is called rebalancing​​. It is an optional step that investors can take to keep the desired asset mix in their portfolios. This does require some activity, but rebalancing is a possible part of both active and passive investing.

Drawing an income can come from either selling part of the positions in stocks or index funds within a portfolio or from dividends.

Dividends are usually a preferred choice, as it allows the original investments to stay invested, generating more dividends and potentially more profit if the price keeps rising.

If the dividends provide more income than needed, investors may reinvest the remainder of the dividends. If the dividends are less than what an investor wishes to withdraw, an investor may consider selling some investments to make up the difference.

Passive investing means the investor has little say over corporate governance, environmental or social issues when it comes to their investments. They are buying a fund, which may include hundreds or thousands of companies, some of which may hold values the investor does not agree with. For example, if an investor is against oil companies, many popular index funds often include oil companies, so for an ESG investor, it’s important for them to look at the individual company holdings of an ETF to make sure they align with their values.

When an individual directly invests in a stock, they may get voting rights or a say in the company. When an investor buys an index fund, the index fund owns the shares, so the individual will unlikely have a say in how the company is run.

Passive investors who care about environmental, social, and corporate governance (ESG) issues can check a fund’s holdings before investing. There are socially and environmentally responsible index funds that endeavour to only invest in companies that are trying to do good for people and the environment.

Some investors believe the market is efficient and that making higher than average returns is very hard to do year-in and year-out. These types of investors are often passive investors.

Other investors believe it is possible to beat the market averages by doing research and buying stocks that may outperform the indexes. These are typically active investors.

Both types of investors and index funds (active and passive) are required to keep the market somewhat efficient. Passive funds buy the stocks on the index, while active funds seek out mispriced stocks through what’s known as price discovery and thus help bring them back to fair value.

Passive investing aligns with the efficient market hypothesis but has been said to inflate valuations as investors become less price sensitive due to automating their investing, buying the index regardless of price and underlying fundamentals. Meanwhile, active investors – the ones who look to beat the index average returns – provide evidence against the market being efficient.

A passive investing feedback loop is a potential danger of passive investing. Typically, the bigger a company becomes, the more indexes it is included in, and more index funds buy the stock. That means more buyers pushing the price up, potentially higher than its fair value based on the company’s operations.

This can be great while times are good because passive investors enjoy nice returns on these popular investments (which are included in the index fund). But because so much money has flowed into these stocks, that also means a lot of money could potentially flow out of them, resulting in large price drops.

Essentially, when passive investing becomes very popular, it has the potential to create bubbles. And when prices start dropping, many people abandon the buy-and-hold strategy and sell, resulting in a flood of selling hitting the stocks held within these index funds.

The reconstitution of an index is when stocks are added or dropped from an index. When these announcements are made by the index, short-term traders​​ buy the additions and may sell or short the stocks that are dropped by the index.

Because of this buying and selling, stocks that are added may see a short-term price rise, while stocks that are removed from the index may see a short-term drop. This is a short-term phenomenon, with prices typically revering after all the buying and selling by the index is completed.

While this presents an opportunity for short-term active traders, it may hurt passive index fund investors since the fund is now buying the stocks they are adding at elevated prices and selling stocks they are removing at depressed ones. This can negatively affect index performance.

Historical returns include these yearly events.

If you're interested in this topic, you may wish to read these investment books​: