What Is Passive Investing?
In recent years, the popularity of passive investing has grown significantly as attitudes towards investing have changed and its accessibility has increased. In this article, we will provide a passive investing definition, highlight the differences of passive vs active investing, demonstrate how you can get started and much more!
Table of Contents
What Is Passive Investing?
Passive investing is a long-term approach to investment with the goal of creating wealth gradually over time.
Proponents of a passive investment strategy believe that, over time, the market will return positive results. They are not interested in profiting from short-term market fluctuations, but instead look to enter a position and hold it over longer periods of time - a strategy sometimes referred to as “buy and hold”.
Passive investors seek to build a diversified portfolio which replicates the performance of the wider stock market. The popularisation and increasing accessibility of index funds has seen this type of investing grow significantly, as these instruments make it far easier for investors to accurately mirror the wider stock market. For the purposes of this article, we will be exploring the concept of investing passively via index funds.
Active Investing vs Passive Investing
It would not make much sense to write an article about passive investing without mentioning its opposing style: active investing.
Active investing takes a more hands on approach to investing and is all about trying to outperform the market. It typically involves increased buying and selling of securities, which requires constant analysis to ensure moves are timed to perfection.
Active investors will pay closer attention to short-term market movements and, if a security which they hold shows signs of dropping in value, they are likely to unload it as soon as possible, as opposed to trying to ride out a downturn.
As well as undertaking this extra analysis and buying and selling themselves, proponents of active investing can also choose to buy shares in a fund which is actively managed. Such funds employ managers to monitor the fund’s portfolio and take decisions on which securities to buy and sell and, just as importantly, when to do so.
Pros and Cons of Passive Investing
Now we know what passive investing is, let’s take a look at some of the pros and cons of passive investing.
Advantages of Passive Investing
There are a number of clear advantages associated with passive investing, particularly if doing so via indexing. In the following sections, we will highlight several of these benefits.
Low Fees
Generally speaking, every time you enter and exit the market you will incur fees. Consequently, the less often you buy and sell assets, the less transaction fees you will pay.
Furthermore, if you are investing in a fund which is actively managed, the fund will charge a higher annual fee, as they need to pay salaries to the fund managers and the teams of analysts researching the markets. The fees for investing in a passively managed fund tend to be far lower as they do not have these expenses to the same extent.
In the short-term, these lower fees may not seem like they make much of a difference. However, over the long-term, they can really add up.
Tax Efficiency
When you sell shares for a profit, you may be liable to capital gains tax. Consequently, the more you sell, the more you may have to pay in capital gains. Furthermore, if buying UK shares, each purchase is liable to stamp duty.
Passive investors are also liable to the same taxes; however, as they tend to trade less frequently, it may result in greater tax efficiency.
Outperforming the Market Is Not Easy
One key thing to bear in mind is the following: it is incredibly difficult to consistently beat the market over a longer period of time. Whilst actively managed investment portfolios may outperform the market from year to year, most fail to replicate this over the long-term.
Standard & Poor’s publishes a regular report on the performance of mutual funds, in which, amongst other things, they analyse the performance of actively managed funds against their benchmark stock index.
In the year ended 31 December 2023, 40% of actively managed large-cap equity funds in the United States managed to outperform the S&P 500 (the report notes that this is above average). However, looking at the ten-year period ending 31 December 2023, this number falls to less than 13%.
Consequently, instead of taking the risk of being one of the many active investors who fail to beat the market over the long-term, a growing number of investors are investing in assets which allow them to replicate the performance of the market year in year out.
Disadvantages of Passive Investing
Of course, there are not only benefits associated with passive investing strategies; there are also drawbacks which explain why many people still prefer to invest actively.
Less Flexibility
Passively managed index funds track an underlying stock index by buying shares in all the index’s constituents.
It holds these shares regardless of what happens in the market, only disposing of them in the event that a company is removed from the underlying index during one of its reshuffles.
Consequently, if one of the fund’s holdings plummets, or there is information available which suggests that such a plummet is imminent, the fund is stuck holding onto it as long as the security remains part of the underlying index.
In scenarios like the above, as well as being able to sell such securities, an active fund is also free to hedge their position using short sales or put options - a technique that is designed to minimise potential losses. Passive funds cannot engage in this activity, they merely continue to hold the securities which are in its underlying index.
Lower Potential Returns
The word potential is important here.
As we identified in the section about the advantages of passive investing, few actively managed investment funds are able to outperform the wider market consistently over the long-term. However, some do.
An index fund is designed to simply track its underlying stock index. The manner in which it does this means that it is unlikely to ever beat the index by a significant margin. In fact, in reality, the return is often slightly lower than its benchmark when you account for fees.
Whilst the percentage of active funds which outperform the market may be low, the fact remains that there are some which do. Of course, the difficulty here is being able to identify these funds in advance. Furthermore, as is usually the case, the increase in potential rewards comes with an increase in risk.
How to Start Passive Investing
At Admiral Markets, investors can buy shares in a wide variety of Exchange-Traded Funds (ETFs), including many which track some of the world’s most popular stock indices such as the S&P 500, the Nasdaq-100, the FTSE 100 and many more!
Follow these steps in order to start investing:
- Open an Invest.MT5 account and log in to the Dashboard.
- Open the web trading platform.
- Search for an ETF or stock and click the symbol to open a price chart.
- Create a new order, enter the number of shares and hit ‘Buy’ to send your order to the market.
Investing with Admiral Markets
Not only does an Invest.MT5 account provide the opportunity for you to invest in over 200 ETFs, but also over 4,500 shares from around the world! Invest.MT5 account holders can also:
- Open an account with a low minimum deposit of just €1.
- Buy fractional shares in more than 700 of the world’s top companies.
- Gain exclusive access to our Premium Analytics portal where you can find the latest market news, technical analysis and market sentiment at no extra cost!
For all this and more, click the banner below and register for an account today:
FAQ
Why is passive investing so popular?
The rise in popularity of passive investing can be explained by its low costs and the fact that, over the long-term, passively managed funds often outperform the majority of funds which are actively managed. However, there are many investors who remain proponents of active investing.
Do passive index funds pay dividends?
Some index funds do pay dividends, yes. However, it depends on the holdings of the underlying index and the type of index fund in question (some index funds automatically reinvest dividends rather than paying them as cash to shareholders).
Is it better to be an active or passive investor?
This depends on the individual investor and the specific investment in question. Passive investing is more suitable for beginner investors and for those who favour the prospect of low-cost, potentially steady returns and low risk.
Active investing is perhaps more suitable for experienced investors who have a more intimate knowledge of the market and who don’t mind the prospect of higher risk in return for higher potential rewards.
Other Articles You May Find Interesting:
About Admiral Markets
Admiral Markets is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world's most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
