Passive Investing: What it is & How it Works

When you invest in a fund, you’ve got two basic options: You can choose to invest in an active fund or a passive fund. In general, passive investing is more of a buy-and-hold approach, while active investing is more proactive, with frequent buys and sells in an attempt to achieve quicker profits.

There was a time when actively managed funds—which can include a mix of stocks, bonds or other assets—were the norm. But over the last decade, investors have been moving billions of dollars out of active funds and into passive ones. The total assets held in active and passive funds are now about equal (as of mid-2019), according to Morningstar.

Although the transfer of billions from active to passive funds happened fairly recently, passive investing is not a new phenomenon. “The concept has been around since 1975, when the late Jack Bogle of Vanguard created the first passive fund,” says Carter Henderson, portfolio specialist and director of institutional development at Fort Pitt Capital Group. “Now, thousands of passive funds flood the market following certain indexes and strategies. The use of passive funds has increased tremendously over the past couple years.”

If passive funds aren’t new, why are so many people moving money into them now?

One reason is because passive funds have been as successful as actively managed funds in recent years—and often more successful. “For U.S. equities, passive strategies have outperformed active funds net of fees from a broad historical perspective,” says Yung-Yu Ma, Ph.D., chief investment strategist at BMO Wealth Management in Portland.

That’s partly because some active funds have high fees and persistent underperformance, Ma says.

But it’s also because access to information—about the management, performance and history of various companies—is widely available online, making markets “more efficient,” says Elijah Kovar, co-founder of Great Waters Financial in Minneapolis. “Information flows so freely, and everybody has access to the same information,” he says. “In the 1980s, there were actively managed funds that outperformed the market continuously, but today, no fund has a 20-year track record that consistently beats the index.”

Back up. What does actively managed mean?

It means a fund is managed by fund managers or brokers, who buy and sell in an effort to outperform an index. Active managers of stock funds, for example, buy and sell shares to try and beat an index like the S&P 500. They rely on information about market trends, economic shifts and other factors that may affect companies’ earnings to make decisions.

With that information, they try to time purchases or sales of investments to take advantage of fluctuations in the market.

While active investment managers may say that they can provide investors with returns that are greater than standard market growth, their active management and frequent trades can result in higher fees for investors, which may cancel out any increased returns.

So what do passive managers do?

Don’t mistake “passive” for “inactive.” When an investment fund or portfolio is passively managed, that just means it’s allocated and maintained in a way that matches a specific index like the S&P 500. By weighting the portfolio or fund to match the index, managers expect it to yield matching returns.

While passive investing isn’t intended to outperform the market, it can yield high returns over time. And since the strategy isn’t proactive, management fees are usually far less.

Are investors dropping active funds because of high fees?

Fees are an issue, since they can wipe out gains, but more investors have probably been turned off by the fact that the vast majority of actively managed stock funds have failed to outperform the benchmark indices over the last decade, according to an analysis by S&P Dow Jones Indices.

In other words, if you’d put money into a passively managed index fund and left it there over time, you likely did better than most people who invested in an actively managed fund that attempted to outperform that same index. And you probably paid less in fees, too.

Another factor is the growing popularity of passively managed exchange-traded funds (ETFs), relatively low-cost stock, bond or commodity funds that are traded like stocks but often track an index. (Commodities include basic goods that are traded like oil, copper and coffee.) And there are now thousands of different ETFs to choose from.

So it pays to be passive?

There are opportunities for growth in both investing styles. Some actively managed funds outperform the indexes, but ETFs, index funds, and some passively managed funds allow you to get into the market for low fees.

There are times when active management may be preferable: During bear markets, for instance, active funds tend not to experience losses as sharply as passive funds do, Ma says. “Losing less money may seem like cold comfort, but this attribute can add protection when investors value it most and also alleviates pressure to sell at inopportune times of market declines.”

Active investing tends to be more successful with different asset classes, or segments of the market. For instance, active managers working with large-cap stocks have the most difficult time outperforming the broader index, “as this area of the market is so crowded and efficient, it is the most covered area of investing,” Henderson says. “But small-cap, international, or bond markets have more inefficiencies. The performance for managers in the latter three areas has been much more on par with passive indexes than the former.”

Individual active investors who pick their own stocks and try to predict where the market will go often end up buying and selling at the wrong times and losing money, says Ben Barzideh, wealth advisor at Piershale Financial Group in Crystal Lake, Ill.

“The vast majority of people who try to time the market will not be able to do it effectively,” he says. “They’ll usually underperform a typical investor who diversifies a portfolio and just sits on the positions and rides out market ups and downs.”

So how do I know which strategy is right for me?

It depends on how much time you have before you’ll need the funds, as well as your emotional appetite for risk. If you won’t need the money you invest for several years, passive strategies may be the best bet—as long as you can avoid making emotional knee jerk reactions.

“The biggest key is your emotional comfort level,” Kovar says. Making a quick decision to sell can be detrimental over the long term—but holding throughout the ups and downs can pay off.

“Many investors overestimate their ability to ride out downturns and a passive investment will participate fully on the downside,” Ma says. “Investors should honestly assess their ability to continue with an investment program in the face of 20, 30 or 40 percent stock market declines and breathtaking headlines.”

The bottom line? Ask yourself if you’re OK with your portfolio performing largely with the market, or if you want to assume the time and risk involved with trying to make better returns than the market, Henderson says. It is worth noting that every market downturn in history has ended in an upturn, and the stock market has continued to grow over time. So, if you can maintain a passive approach and continue to invest regularly, it may pay off.