For many investors, passive investing has one overriding problem: the name.
The term “passive” can suggest compromise, the idea that the goal of obtaining superior investment results through a more hands-on approach (i.e., moving in and out of the market or attempting to pick the best strategies or managers) is not worth the effort. In other words, settle for less and be content with it.
That’s far from the case. Not only has passive investing outperformed active strategies, it can also proactively head off mistakes and missteps that often plague investors.
Passive Investing Defined
Passive investing is relatively simple at its core. One form of passive investing involves a “buy and hold” approach, which keeps trading to a minimum. Passive investors put together a portfolio of securities and hold onto it for years.
Passive investing can also be defined by investment vehicles that eliminate the need to select individual securities and offer immediate diversification, often at a lower cost. These include index mutual funds—funds built to track an index such as the S&P 500—and exchange-traded funds (ETFs), which are marketable securities that may also track an index of stocks or other securities but trade like a common stock on an exchange.
The Positives of Passive Investing
Critics of passive investing argue that better results are possible through a more active approach. They believe that moving in and out of positions maximizes returns while limiting losses.
That argument doesn’t hold water, historically speaking, even for active money managers (professionals who engage in security selection in order to outperform benchmarks). According to the investment research company Morningstar, while active investment manager performance has improved somewhat in 2017, it still lags passive index funds. To that end, less than half of active U.S. stock funds beat their composite passive benchmarks in the 12-month period ending June 30. The longer-term data is even more grim for actively managed strategies. Over 10 years, 85 percent of active funds in the U.S. have failed to beat relevant benchmarks1. Nor is this just a U.S. stock phenomenon. Active managers consistently underperform U.S. and international stock and bond market benchmarks alike.
Down Market? Stick With Passive
Another claim by skeptics is that passive investing can limit investor flexibility. Given that, in addition to trying to select winners, active investors frequently abandon positions and move into cash in falling markets, they’re supposedly better positioned to limit damage than passive investors who just sit on their hands and “take it.”
Again, the evidence suggests otherwise. For one thing, active investors typically incur more trading fees and other expenses as they pursue this active “tactical” method. And, since passive investors don’t abandon in a down market, they may be better positioned to benefit on those days when it rebounds. In a recent Vanguard study of the S&P 500, 19 of the 20 worst days in the market occurred within a month of one of the 20 best days2. That suggests active investors who try to time the market can be on the sidelines while their passive counterparts benefit.
Low costs are another appealing element to passive investing. According to the Investment Company Institute, the average expense ratio of actively managed equity mutual funds in 2016 was 0.82 percent. By comparison, average index equity mutual fund expense ratios were a relatively slim 0.09 percent, or 89% lower3! That’s money out of investors’ pockets from the outset, no matter how well a fund performs. It’s important to note that the compounding effect of investment returns also applies to costs, so investors must be careful when selecting expensive products that may eat away at returns over time.
One last advantage of passive investing is the lower potential tax impact. An active approach can be its own worst enemy when it comes to money owed to Uncle Sam; the more buying and selling that occurs, the higher the potential tax consequences. By contrast, the buy and hold approach of passive investing that limits trades also limits tax exposure, since investors minimize short-term capital gains—which are taxed at ordinary income rates.
Meet The Enemy: Ourselves
Statistical evidence aside, psychological research shows that a buy and hold approach addresses a human propensity for overreaction. Often, investors faced with a volatile or declining market are tempted to do something when standing pat may be the best option. In contrast, passive investing (buy and hold) and passive investment choices (index funds that you buy and hold) are designed to remove that sort of temptation.
But that does require some discipline of its own. Success with passive investing requires a commitment to staying the course, even as others are bailing out of the market. Confidence that the markets will ultimately benefit those who remain invested can mean fighting against our human nature to take shortsighted action. And that can be a challenge for any of us.
Ultimately, investors are better served by focusing on things within their control, such as costs, diversification and taxes. By taking a long-term, disciplined approach to investing and utilizing buy and hold rather than trying to second-guess markets, investors can experience more reliable investment outcomes to help achieve important financial goals.