There are two types of investors: Those who try to beat the market (active) and those who seek to just match the market’s performance (passive).
Passive investing means buying index funds or exchange-traded funds (ETFs) that track the ups and downs of indexes or benchmarks — like the Standard & Poor’s 500 Index (S&P 500).
Most folks who have money in the markets are passive investors, including myself. Over the last few decades, index funds have become the top choice among passive investors because you can build and manage a low-cost, diversified portfolio with minimal effort. And the passive approach produces better returns on average than going active.
What Is Active Investing?
In industry lexicon, active investing is referred to as active management. To beat, rather than match, the performance of an index like the S&P 500, active investors can buy an “actively” managed mutual fund.
These funds have investment managers and management teams that pick stocks, bonds, and other securities that they expect to outperform their benchmark or simply add value to an investment portfolio.
In contrast, passive investors buy index funds and ETFs that don’t have managers making investment decisions. The index or benchmark does that. Active also means paying more — a lot more — in fees and other costs to beat a fund’s benchmark.
What Is Passive Investing?
In order to understand passive investing, you need to understand how indexes work. Indexes are complex averages that mirror the overall performance of a certain market (such as Asian stocks) and that market’s health going forward.
Investors have thousands of index funds and ETFs from which to choose —it really is index galore.
The most popular index is the S&P 500, which tracks 500 of the largest stocks by market capitalization (Apple is No. 1 at $1.9 trillion market cap).
Other popular U.S. market indexes include the Nasdaq Composite (which tracks over 3,300 tech stocks), the Russell 3000 (small companies by market cap), and the Wilshire 500, which represents the total stock market.
Outside the U.S., there are indexes that track the stocks of companies in developing and emerging markets or track currencies or commodities like gold. You can buy funds that track individual sectors like technology or utilities, as well as regions and cities.
Want to invest in the total global market? Try the MSCI All Country World Index, which tracks 2,400 stocks in 47 markets.
Active Trading vs. Passive Investing
Index funds offer investors broad diversification and have low turnover. In other words, the funds don’t buy and sell stocks all the time. This helps keep transaction costs down. Lastly, index funds charge low expense ratios — much lower than actively managed mutual funds.
According to the Investment Company Institute, the average expense ratio last year for index funds was 0.08 percent vs. 0.76 percent for actively managed funds. That’s a huge difference. In money terms, that’s a difference of being charged annually 80 cents or $7.60 on $1,000 invested, respectively.
Active funds suffer from a double whammy of high transaction costs from chronic trading and high management fees (expense ratio).
For these two reasons, index funds typically outperform active funds. And index funds do even better when markets are healthy. How do you beat fat and happy?
A Bit of History
It all began in 1975, when Jack Bogle, founder of mutual-fund powerhouse Vanguard, launched the first index fund. Stock picking by active fund managers, he concluded, was no match for passive, index-based investing — both in terms of cost and in terms of performance.
Bogle made the right bet. His low-cost mutual fund revolutionized the investment industry.
Today, that first index fund — the Vanguard 500 Index Fund — has grown into the world’s biggest, with more than $560 billion under management. It has a 0.14 percent expense ratio.
Bogle argues that investors should “rely on the math. … The fundamental underlying success of indexing is not based on any mystique. It’s based on gross returns in the stock market minus cost equals net return.
Hold high the idea of simplicity in investing and avoid trading because trading gives more money to Wall Street and less money to the investor.”
Why Passive Investing Has Many Critics
As Bogle noted, Wall Street makes a lot more money off investors in actively managed mutual funds. The masters of the universe of The Street will do anything to tear down index investing.
Critics complain that passive investors have a herd-like mentality, which inflates or overvalues the prices of stocks and other assets (what you call bubbles). In other words, passive investors place too many eggs in one basket when there are many other baskets available.
Active managers, they say, are free to invest in anything they want in an effort to produce returns that beat the market.
Of course, that costs a lot more money than betting on a simple index of stocks.
Critics also argue that there could be a correlation between the success of passive investing and the fact that the stock market has done well over the last 30 years. Active managers will prove their worth when the markets are falling, critics say.
In fact, the active crowd might get its chance in the next few years. Market watchers predict investors can expect low single-digit market returns for years. Active managers could be called on to produce returns just to beat the inflation rate. Maybe.
The Bottom Line on Passive Investing
Passive investing is here to stay. Not just in the U.S., but around the world. Many large pension funds and institutional investors use passive-investing strategies.
It comes down to cost — and the savings earned year after year. That’s why index funds deliver returns that are superior to those of active funds.
If you’re wealthy and have a lot of time to watch over your investments, using active funds might work for you. But if you’re a simple retail investor saving for a new home, college, or retirement like most of us, passive investing is the smartest, most cost-effective strategy for the long term.