Passive investing is an investment strategy whereby investment portfolios try and generate returns that mirror the returns of the main markets, main indexes or different assets classes i.e. developed markets, emerging markets, bonds, etc. Overall, passive portfolios may be built using several exchange-traded funds (ETFs), which track a different market index, like the S&P 500, thereby linking investors' performance directly to that of all of the companies in that market, rather than just one or two of them.
Key pros – why investors like passive investing
- Low costs - passive investing directly through ETFs is the cheapest way to access the market, with typical ETF costs ranging from 0.1% to 0.2% annually. However, if you want to have a portfolio being built with more than one ETF, which will be managed daily, you need to take into account additional management fees. However, typically the total management fee for this kind of investment products are in the range of 0.5% and 0.8%, which is much below the average for the actively managed mutual funds (typically more than 1.0%, including in some cases additional so-called success fees).
- Strong results in the long term - If you are prepared to invest your money over a long period of time (typically 10 years), the stock markets have historically delivered positive results. For instance, between March 2007 and March 2017, the FTSE 100 had returned 15.46% despite several prolonged periods of volatility. In addition to such a long horizon, passive investing delivers better results than active investing.
- Simplicity and diversity - with a passive investment, you always invest in well-diversified products such as ETFs, which reduces the potential risk of investment. In addition, you do not have to know the fundamentals of the companies you invest in as you rather bet that the entire market moves up, not the particular company.
Key cons – why passive investing is not a perfect solution
- Limited returns – with passive investments you will never beat the market – because ETFs are the market itself.
- Volatility – ETFs remain volatile similarly to the regular stocks, however, given that in the recent years, the popularity of ETFs has increased, their volatility may increase in the future and enhance market fluctuations.
- ETFs have not passed yet any bear market test – so we do not know how they will behave during a typical bear market. However, there is some material risk that significant redemptions of ETFs may increase the scale of drawdowns especially for the most liquid stocks, which usually constitute the major portion of the global market’s capitalization.