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What is Passive Investment Management?

Investing


One of the most debated items in retirement planning is how one should be invested in retirement. Today we are going to discuss what passive investment management is and how it works. 

What you will learn:

  • Passive Investment Management 
  • What is active investment management?
  • Passive investing goes hand in hand with index funds
  • The benefits of passive investing
  • Drawbacks of passive investing
  • Conclusion 


PASSIVE INVESTMENT MANAGEMENT

Passive investing is an investment strategy used to maximize returns by minimizing buying and selling. Index investing is one form of passive investment that involves purchasing a fund or ETF that models a representative benchmark or index, such as the S&P 500 index, and maintaining it for a lengthy period of time. Passive investment techniques aim to avoid the costs and poor performance associated with frequent trading in active mutual funds. Passive investing’s goal is to build wealth gradually. Also known as a buy-and-hold strategy, passive investing means buying a security to own it long-term.

Many investors are familiar with this concept thanks to John Bogle, the founder of mutual fund company Vanguard.  Passive investing has grown in popularity, but it wasn’t always so. For example, Bogle launched Vanguard over 40 years ago with the idea that most actively managed funds would not measure up to their benchmarks, and passively managed index funds were a better bet for investors. At first, many people dismissed his ideas as inferior to active management strategies. However, today passive investing is an increasingly popular strategy because of its long-term success compared to active managers who may charge higher fees while underperforming their benchmark. Passive investment strategies are beneficial for both individual investors and institutions looking for above-average returns without high turnover or large capital gains distributions.

In comparison, active investment management is an investment strategy that tries to beat the market by actively trading in and out of different investments.

WHAT IS ACTIVE INVESTMENT MANAGEMENT?

Active portfolio management is the strategy of buying and selling stocks to outperform the entire stock market, a specific index, or sector. For example, an investor who follows this approach will frequently buy and sell stocks based on financial analysis or even rumors. When mutual funds use active management, they usually charge more in fees than a passive fund due to the extra time and knowledge used in following the strategy.  Often, between the higher fee and poor investment selection they underperform their relative benchmark.

Each year, Morningstar analyzes active and passive funds to see how the funds stack up against their benchmark. For 2020, they analyzed 3,500 active funds and found that only 49% were still open and had outperformed their benchmark. In addition it is extremely difficult to determine from year to year which active funds are going to be able to outperform their benchmarks every year. 

PASSIVE INVESTING GOES HAND IN HAND WITH INDEX FUNDS

As passive investing has grown over the decades so has the number of index funds. An index fund is a type of mutual fund or exchange-traded fund (ETF) with a portfolio of stocks or bonds constructed to match or track the components of a financial market index, such as the Standard & Poor's 500 Index (S&P 500). There are many indexes for mutual funds and ETFs to track. A few examples are those that track bond markets, regions of the world, sectors, and stock of companies that are a specific size.

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 by holding all, or a representative sample of the securities in their target benchmarks.


THE BENEFITS OF PASSIVING INVESTING

Some of the key benefits of passive investing are:

  • Ultra-low fees:  With passive investing, you won't have to pay for research or trading costs. Likewise, you can avoid paying high fees associated with active mutual funds that
  • Transparency:  You know exactly what you're getting when it comes to passive index funds. You will have a clear picture of how much risk you are taking and what companies you own via the index.
  • Diversification: Passive investing can provide a much more diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk.
  • Tax efficiency:  With passive investing, you won't be worried about short-term capital gains taxes. You will also avoid paying high fees that can eat into your returns
  • Simplicity:   Passive investing is relatively simple to understand, especially when compared with more complicated types of investments


    THE DRAWBACKS OF PASSIVE INVESTING

    All investing strategies have some risk, and passive investing is no exception. Before you decide to use passive investing as part of your financial planning, you should be aware of the potential risks:

    Fixed Market Returns

    Passive investments track an index rather than individual assets. As a result, your returns will be close to those of the indexes in which you invest. With that in mind, it is not possible to "beat the market."

    Cannot Opt-Out of Underlying Asset Investments

    When you buy an ETF or mutual fund, you do not have the ability to pick the underlying investments. Passive ETFs and mutual funds follow indexes. Therefore, they invest in all the assets within those indexes. You have no say in what the ETF or mutual fund invests in. For example, you can't sell or buy a specific stock within an ETF or mutual fund.

    CONCLUSION 

    If you want to simplify your retirement investing, passive investing might be for you. Passive investors buy and hold securities over a long time horizon to avoid the fees and limited performance that may occur with frequent trading inside of active mutual funds. This strategy is also called "buy-and-hold." Index investing is one common example of this type of investment strategy whereby investors purchase a representative benchmark like the S&P 500 index and hold it for many years or even decades. You can learn more about how we use these principles at Gudorf Financial Group, LLC.


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    Disclosure: Investors should carefully consider the investment objectives, risks, fees and expenses before investing.  For this and other important information please obtain the investment company fund prospectus and disclosure documents from your financial professional.  Read this information carefully before investing. Indices mentioned are unmanaged and cannot be invested into directly.