What is passive investing?
Passive investing is investing for the long term when you follow a set of rules rather than picking individual investments
Passive investing is a strategy to maximize returns by minimizing buying and selling. Its goal is to build wealth gradually with the assumption that financial markets have positive returns over time. Index investing in one common passive investing strategy whereby you buy a representative benchmark, such as the S&P 500 index for US equities, and hold it over a long time horizon.
Passive management is often contrasted with active management where managers buy shares they believe to be undervalued and sell shares they believe to be overvalued. Which is best for investors is the subject of much debate in the investment community although the debate is pretty much settled in the US where the bulk of retirement investments is now managed passively.
Passive managers generally believe it is difficult to out-think the market over time. Active managers who pick shares may be successful at times but most of them are unlikely to do better than the market over long periods of time. Passive investing attempts to replicate market performance by constructing well-diversified portfolios of single stocks, which if done individually, would require extensive research. The introduction of index funds in the 1970s and ETFs in the 1990s made achieving returns in line with the market much easier and cheaper.
In practice, most very large pension funds (such as the NZ Super Fund) now use a combination of both approaches: a core of passive funds to provide long-term sustainable growth and smaller “satellites” of actively managed funds aimed at adding some value in specialised areas.
Passive Investing Benefits and Drawbacks
- Diversification - Benefit: Maintaining a well-diversified portfolio is important to successful investing, and passive investing via indexing is an excellent way to achieve diversification. Index funds spread risk broadly in holding all, or a representative sample of the securities in their target benchmarks.
- Low fees - Benefit: Index funds track a target benchmark or index rather than seeking winners, so they avoid constantly buying and selling securities. As a result, they have lower fees and operating expenses than actively managed funds. Lower fees make a huge difference over time. For example, a fee difference of 0.5% per year adds up to over 10% of the balance over 20 years.
- Exposure to market risk - Drawback: Passive investing is subject to total market risk. Index funds track the entire market, so when the overall stock market or bond prices fall, so do index funds. They are not flexible because index fund managers usually are prohibited from using defensive measures such as reducing a position in shares and increasing cash levels, even if they think the market will fall.
- Limited performance upside - Drawback: Passive funds will pretty much never beat the market, even during times of turmoil, as their core holdings are locked in to track the market.
Active Investing Benefits and Drawbacks
- Flexibility - Benefit: Active managers aren't required to follow a specific index. They can buy those "diamond in the rough" stocks they believe they've found. They can move into cash if they believe the market will fall.
NZ active managers advance the argument that the NZ equity market is not as efficient as other markets because of its small size. They claim that it is still possible to outperform the market index by selective share picking. While this has been true in the past, it is no longer the case now.
- Hedging - Benefit: Active managers can also hedge their bets using various techniques such as short sales or put options, and they're able to sell specific stocks or sectors when the risks become too big. Passive managers are stuck with the stocks that the index they track holds, regardless of how they are doing.
- Higher costs - Drawback: Fees are higher because all that active buying and selling triggers transaction costs, not to mention that you're paying the salaries of the analyst team researching equity picks. All those fees over decades of investing can kill returns.
- Active risk – Benefit & Drawback: Active managers are free to buy any investment they think would bring high returns, which is great when the analysts are right but terrible when they're wrong. To beat the index requires that you find winners year after year and that is only achieved by very few active funds.
- Poor track record - Drawback: The data show over medium to long time frames, only a small handful of actively managed funds beat their benchmark index after fees and taxes.
What does kōura do?
kōura believes index investing will provide a better return over the very long horizon for a typical KiwiSaver investor. kōura mitigates the market risk by recommending a mix between riskier growth assets and safer income assets which are appropriate for the investor’s personal situation.
To find out more about passive investing, please see our blog post here.