Passive Investing Definition and Pros & Cons, vs. Active Investing

Passive investing is an investment strategy to maximize returns by minimizing buying and selling. Index investing is one common passive investing strategy whereby investors purchase a representative benchmark, such as the S&P 500 index, and hold it over a long time. Passive investing can be contrasted with active investing.

Understanding Passive Investing

Passive investing methods seek to avoid the fees and limited performance that may occur with frequent trading. The goal of passive investing is to build wealth gradually. Also known as a buy-and-hold strategy, passive investing means purchasing a security to own it long-term. Unlike active traders, passive investors do not seek to profit from short-term price fluctuations or market timing. The market posts positive returns over time is the underlying assumption of passive investment strategy.

Passive managers generally believe it is difficult to out-think the market, so they try to match market or sector performance. 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 made achieving returns in line with the market much easier. In the 1990s, exchange-traded funds, or ETFs, that track major indices, such as the SPDR S&P 500 ETF (SPY), simplified the process even further by allowing investors to trade index funds as though they were stocks.

Passive Investing Benefits and Drawbacks

Maintaining a well-diversified portfolio is important to successful investing, and passive investing via indexing is enables investors to achieve diversification. Index funds spread risk broadly in holding a representative sample of the securities in their target benchmarks. Index funds track a target benchmark or index rather than seeking winners. Thus, they avoid constantly buying and selling securities. As a result, they have lower fees and operating expenses than actively managed funds.

An index fund offers simplicity as an easy way to invest in a chosen market because it seeks to track an index. There is no need to select and monitor individual managers, or chose among investment themes.

However, 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. Another risk is the lack of flexibility. Index fund managers usually are prohibited from using defensive measures such as reducing a position in shares, even if the manager thinks share prices will decline. Passively managed index funds face performance constraints as they are designed to provide returns that closely track their benchmark index, rather than seek outperformance. They rarely beat the return on the index, and usually return slightly less due to operating costs.

Some of the key benefits of passive investing are:

• Ultra-low fees: There's nobody picking stocks, so oversight is much less expensive. Passive funds follow the index they use as their benchmark.
• Transparency: It's always clear which assets are in an index fund.
• Tax efficiency: Their buy-and-hold strategy doesn't typically result in a massive capital gains tax for the year.
• Simplicity: Owning an index, or group of indices, is far easier to implement and comprehend than a dynamic strategy that requires constant research and adjustment.

Proponents of active investing would say that passive strategies have these weaknesses:

• Too many limitations: Passive funds are limited to a specific index or predetermined set of investments with little to no variance. Thus, investors are locked into those holdings, no matter what happens in the market.
• Smaller potential returns: By definition, 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. Sometimes, a passive fund may beat the market by a little, but it will never post the big returns active managers crave unless the market itself booms. Active managers, on the other hand, can bring bigger rewards (see below), although those rewards come with greater risk as well.

Active Investing: Benefits and Limitations

To contrast the pros and cons of passive investing, active investing also have its benefits and limitations to consider:

• Flexibility: Active investors aren't required to follow a specific index. They can buy those "diamond in the rough" stocks they believe they've found.
• Hedging: Active managers can also hedge their bets using various techniques such as short sales or put options, and they're able to exit specific stocks or sectors when the risks become too big. Passive investors are stuck with the stocks that the index they track holds, regardless of how they are doing.
• Tax management: Even though this strategy could trigger a capital gains tax, advisors can tailor tax management strategies to individual investors, such as by selling investments that are losing money to offset the taxes on the big winners.

But active strategies have these shortcomings:

• Very expensive: 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. In 2020, the average fee for actively managed mutual funds was 0.71% while fees for passively managed funds were an average of 0.06%.
• Active risk: Active managers are free to buy any investment they think would bring high returns, which is great when the analysts are right but detrimental when they're wrong.
• Poor track record: The data show that very few actively managed portfolios beat their passive benchmarks, especially after taxes and fees are accounted for. Indeed, over medium to long time frames, only a small handful of actively managed mutual funds surpass their benchmark index.

The Bottom Line

Passive investing has pros and cons when contrasted with active investing. This strategy can be come with fewer fees and increased tax efficiency, but it can be limited and result in smaller short-term returns compared to active investing. Passive investment can be an attractive option for hands-off investors who want to see returns with less risk over a longer period of time.