What is passive investing and how does it work?

What is passive investing?

The fundamental characteristic of a passive investment is that it seeks to replicate a part of the market and track its performance. The theory is that markets tend to go up over time and by, in effect, holding all of the constituents of a specific index or sector you will make money over time. As such, when you choose passive investments, you tend to buy and hold rather than make frequent changes to your portfolio.

Passive investing has grown in popularity in recent years, driven, in part, by the fact passive investments are generally relatively low cost and can often outperform their active counterparts. Investors tend to favour passive investments that track broad market indices, such as the S&P 500 or FTSE 100, as they offer good levels of diversification and have a long track record. However, it's also possible to use passive vehicles to gain exposure to more specialist areas, such as commodities or real estate.

What are the different ways you can passively invest?

The two main types of passive investments are passive funds - also known as index or tracker funds - and exchange-traded funds (ETFs). The main difference between the two is how they are structured and the way in which they are bought and sold.

Passive funds

When you invest in passive funds, the money you put in is pooled with other investors' money and used to buy the underlying components of the particular index or sector the fund is tracking. If, for example, you are investing in a FTSE 100 index fund, it will invest in all 100 companies that make up the index, with the same weighting as in the index. The aim is to replicate it as closely as possible.

With a passive fund, you can buy a share in the fund through the investment company itself, or through a broker. They only trade once a day, at the end of the trading session. When you want to sell your holding, you can either sell it back to the investment company or through the broker.

ETFs

As ETF is similar to a passive fund in as much as aims to mirror the index or sector it is tracking as closely as possible. However, it is structured in the same way as a share and is listed on a stock exchange. This means it can be traded freely throughout the day. When you want to sell an ETF, you need to use a broker or platform rather than being able to sell it back to the investment company that issued it directly.

For more details on ETFs, read our article "What is an ETF - and is it the best investment for you?"

How does passive investing work?

While, in theory, it is possible for an individual investor to create their own index portfolio by investing in every company in, say, the S&P 500, at the correct weightings, it is likely to be expensive and difficult to implement. It is also likely to result in a high "tracking error", which is the degree to which the passive investment differs from the underlying index it is trying to replicate.

Passive funds and ETFs allow a simple solution, recreating the index or sector for you as well as rebalancing the fund as it changes over time, ensuring it remains as accurate a replication as possible. It does this by either using a financial institution to buy the underlying assets and creating a "physical" fund or, alternatively, using "swaps" to create a "synthetic" fund. Swaps are instruments that pay the same return as the underlying holding but mean you don't actually own the real, physical component.

Passive vs Active investing

The main difference between a passive and active investment is the fact that passive vehicles are aiming to mirror the performance of the part of the market they are attempting to replicate, rather than trying to beat it. Active funds, meanwhile, work on the basis that a fund manager can outperform the market - or the specific benchmark for their fund - by using their own insight and selecting holdings they think will do well. There is also an element of timing the market and, again, using the knowledge and expertise of the fund manager, as well as the many research tools at their disposal, to add "alpha". Alpha is the return you get over and above what you would have achieved by simply tracking the market.

The downside of investing in an actively managed fund is it is usually significantly more expensive as you have to pay for the fund management that is on offer. In addition, there is no guarantee the fund manager will always outperform the market and, in many cases, active funds will go through periods when they underperform the market because of volatility and uncertainty or because of poor judgement on which stocks are going to perform well.

Advantages of passive investing

Diversification

When you opt for an ETF or passive fund, you instantly invest in a large number of companies that make up the underlying index you are tracking. By combining passive vehicles in a number of different asset classes - for example, fixed income, equities and commodities - as well as in different industry sectors and geographical regions, you can create a portfolio that is well diversified.

Alternatively, there are a wide range of risk-rated, ready-made passive funds that combine the investments for you to ensure a diversified portfolio that reflects your attitude to risk.

Low cost

With an active fund, you have to pay for the expertise of the fund manager, which is generally between 1.00%-1.75%, however, the fees for passive vehicles are usually only around 0.20%, which means there is far less drag on returns. Additionally, as passive investing lends itself to a "buy-and-hold" approach, you are less likely to incur further charges for buying and selling holdings on a regular basis.

Outperformance

Research shows that over the long term, only around 25% of active funds will outperform their passive counterparts. This means that, if you are investing for longer than 10 years, statistically you are likely to be better off with a passive portfolio.

Disadvantages of passive investing

Lack of control

If you track a certain index, you will automatically invest in every company within it. This means if an individual holding or group of holdings is starting to struggle, you can't choose to remove them from your portfolio. Equally, if a company and its activities do not fit with your beliefs, you won't be able to avoid it, unless you choose a different passive fund, perhaps from an ethical portfolio range.

Less skill and excitement

For some investors, taking an active approach to managing a portfolio in an attempt to boost performance is part of the fun. With passive investing, there isn't the same potential for trying to outperform the market and identifying the winners and losers from the wide array of funds and shares that are available.

How to invest in passive funds and ETFs

For a detailed guide on the best ways to access passive investments, read our guides "What is the best way to invest in index funds or ETFs" and "How to successfully invest £10,000". However, in summary, there are three main ways to invest in passive vehicles:

Robo-advisers

In recent years, there has been a growing number of robo-advisers, including Nutmeg, Wealthify* and Moneyfarm*, which work by assessing a prospective investor's attitude to risk and return requirements and then creating a ready-made portfolio. They provide a low-cost option because they invest primarily in passive vehicles, which keeps the fees low. The platform fee they charge varies, as does the type of products, wrappers and services. For more information, check out our article "Which is the best robo-adviser in the UK?"

Additionally, to find our current list of the best robo-advisers, including the latest offers and fees check out our best-buy table.

Traditional investment platform

The long-established, traditional investment platforms such as Hargreaves Lansdown*, Interactive Investor* and AJ Bell*, all allow investors to invest in passive funds, either by selecting them individually to include in a broader portfolio or in their own ready-made portfolios. Again, the overall offering and costs vary, so you may be interested in our article "The best investment platform".

Trading platforms

Platforms such as Freetrade*, eToro and Trading 212 are targeted at investors who want to take a more active approach to investing, with the option to buy and sell shares and funds at a low cost. It is, however, possible to invest in ETFs through these platforms and, with most of them structured with low, or no, commission fees, it can work out to be a cost-effective way of investing. There is a summary of the top-5 trading apps available in our article "Best trading apps for beginners in the UK".

 

 

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