Passive Investing Is Moving Up

Broadly speaking, investors have two types of strategies to pursue: active and passive. Recently, passive investing has gained popularity. In 2013, for example, net investments into passive equity funds topped $60 billion, versus $3.4 billion for active funds. Should you be an active or a passive investor, or should you use both methods? To make an informed decision, you should know the background.

Sitting on a Benchmark
Historically, investing was an active endeavor, in today’s terms. (This discussion will focus on stocks, but the principles apply to all investment securities.)

Example 1: In the early 20th century, young John Smith could pick his own stocks, perhaps based on the proverbial hot tip, or he could buy stocks suggested by his securities broker. In the middle of the century, John’s choices expanded. He could hire a professional money manager to pick stocks for him (assuming John had a sizable amount to invest), or he could put his money into a publicly offered fund and let the fund manager select the fund for him. In all of these modes, John hoped that the stocks he owned, directly or through a fund, performed well. He was following an active investment strategy. When the 20th century moved toward its end, investors had another option: They could invest in an index fund. Such funds do not rely on stock picking; they allow individuals and institutions to invest in a broad segment of the stock market.

Example 2: John’s granddaughter Sue Jones decided to invest in a fund that tracks the S&P 500 Index, a benchmark for large company U.S. stocks. This fund (and Sue, as a shareholder) holds the stocks in the index. As the broad stock market goes up or down, the value of Sue’s investment flows and ebbs. As mentioned, index funds, such as the one in which Sue invests, have become widespread. You can find funds tracking indexes of bonds, small company stocks, foreign stocks and other asset classes.

Assessing Their Appeal
With all of the advantages of passive investing, why go active? For one reason, there will be some active managers who deliver returns greater than their benchmark indexes over the next 10 or 20 years or longer. Even modest outperformance can make a huge difference in long-term wealth building. In an index fund, you have no chance of profiting from a wise manager selection. In addition, major market indexes are primarily “cap weighted,” that is, the stocks in such indexes are held in proportion to the total market value of their shares. (See the “Weight Watching” Trusted Advice box.) At times, cap weighted indexes become heavily tilted towards tech stocks, oil companies, banks, or whichever market sector is in favor. Rising prices boost market capitalization for such companies. When these companies lose some appeal, as inevitably happens, the index may drop sharply, pulling down index funds.

Weighty Woes
With all of the advantages of passive investing, why go active? For one reason, there will be some active managers who deliver returns greater than their benchmark indexes over the next 10 or 20 years or longer. Even modest outperformance can make a huge difference in long-term wealth building. In an index fund, you have no chance of profiting from a wise manager selection. In addition, major market indexes are primarily “cap weighted,” that is, the stocks in such indexes are held in proportion to the total market value of their shares. (See the “Weight Watching” Trusted Advice box.) At times, cap weighted indexes become heavily tilted towards tech stocks, oil companies, banks, or whichever market sector is in favor. Rising prices boost market capitalization for such companies. When these companies lose some appeal, as inevitably happens, the index may drop sharply, pulling down index funds.

Seeking a Better Blend
Some investment companies have attempted to improve the performance of traditional cap weighted index funds by devising “enhanced” indexes, then offering funds to track those indexes.
These include equal weighted indexes: each stock in an S&P 500 index fund might be represented by 1/500 of the fund’s assets, for instance. Alternatively, major indexes might be tweaked to give more weight to stocks that pay dividends or to stocks that historically have been less volatile than the broad market. These enhanced index funds have an active component: They’re designed to accentuate some attribute the fund sponsor believes will improve results. Many enhanced index funds are relatively new, so it may be too soon to judge the success of these efforts. However, the basic rule applies to all funds, whether they’re active or passive or somewhere in between. Before investing, you should know how the fund will operate and be comfortable with its approach.

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