Passive investing practices gain appeal over active investing
Unsatisfactory performance of actively managed funds is pushing investors towards passive investing. Within the last decade, approximately $1.2 trillion has been transferred to mutual funds and exchange traded funds, or ETFs, which are designed to track large caps and popular indices such as the S&P 500. This growing trend presents the possible risk that passive investors will not benefit from their investing strategy, as active investment funds are critical in helping price securities efficiently.
Portfolio managers who actively invest put immense effort into researching markets in which to buy and sell securities, resulting in high management and transaction fees that are passed along to their investors.
By contrast, investing in a passively managed fund requires little research or attention to markets and faces lower management and transaction fees. Taking the passive approach that costs less than active management has become much more popular among smaller investors as of late.
Active management may be more useful for larger firms that have enough resources and manpower to do so effectively. Actively managing a portfolio can be very effective, especially in the short run, if investors have the money to buy and sell large amounts of securities frequently. Investors should be able to take advantage of a stock’s momentum and profit from the frequent transactions.
Passive investing is appealing to investors who are more risk averse, reluctant to deal with time consuming market analysis and willing to hold investments for long periods of time.
Besides the fact that passively invested funds cost less than actively managed ones, firms with passive investment strategies are continuously outperforming both hedge funds and firms with actively managed funds.
It has always been difficult for managers to consistently beat the market, and since the 2008 financial crisis and subsequent recession, this has increased.
Both institutional and individual investors benefit from investing in funds such as the Vanguard 500 Index Fund, also known as VFINX, that track the performance of its benchmark index, the S&P 500.
The Standard and Poor’s 500 index consists of 500 stocks chosen by economists to reflect the performance of large cap U.S. equities. The index acts as a benchmark for investors and is important in decision making and measuring the performance of their portfolios.
The most important measures of a portfolio’s performance are beta and alpha. Passive investment portfolios will have a beta very close to one and an alpha close to zero. This means that the price of the fund behaves in the same or in a similar manner to the market, and that actual returns did not differ from market returns.
In other words, passively invested portfolios track market performance one-to-one. This is harder to achieve with actively managed funds.
Baruch student Erica Bowman said, “Passive investing takes the research and guesswork out of the stock market, making it easier for everyone, like college students, to invest.” Institutional investors should also invest in passive funds. With the large investments that institutional investors make, cost reduction is a top priority.
The many boards of directors that control large companies are beholden to their shareholders, with their main goal being to maximize profit. Reducing the cost of investing, and likely outperforming actively managed funds by passively investing, could be seen as an intelligent decision that shareholders might agree with.
The Vanguard Group, one of the world’s largest investment companies, was one of the first to offer investment products that required an initial investment of only $3,000. The investment was attractive to individual investors with little capital.
According to the company website, the Vanguard 500 total annual fund operating expenses amount to only 0.14 percent, 86 percent lower than the average of funds with similar holdings.
Among over 500 different stocks, Vanguard 500 has their largest holdings in companies like Apple Inc., Johnson & Johnson, Exxon Mobil Corp., and JPMorgan Chase & Co. Index funds like this gives investors the ability to reduce risk by diversifying their portfolios.
The effectiveness of Vanguard’s approach is evidenced by their increasing inflow of funds and their $3.826 trillion of total assets under management, which is more than its competitors combined.
Risk is a large concern for any investor—another reason why passive investing, which mitigates risk, has surged in popularity compared to active investing. However, to attain a higher rate of return on an investment, a higher risk is necessary.
There are two types of risks: systematic and unsystematic. Unsystematic risk comes with a specific company or industry and should be minimized. Risk can be reduced through diversification. Systematic risk comes with the market overall. The more systematic risk an investor is willing to take, the higher their earnings potential.
Currently, taking on less risk with passive investing seems optimal, but there are a small number of firms that are beating the market with much higher returns. Whether or not they will beat the market consistently remains to be seen.