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What Is Passive Investing? - Pros and Cons

April 26, 2021 17:10 UTC

Passive investing is an investment approach which can often divide opinion amongst investors. There are those who strongly favour it but others who advocate for its opposing style - active investing. However, in recent years, the popularity of passive investing has grown significantly as peoples’ attitude towards investing has changed.

In this article, we will examine what passive investing is, compare it with its active counterpart, analyse some of its advantages and disadvantages and show you how you can get start investing with Admirals (formerly Admiral Markets)!

What is Passive Investing

What Is Passive Investing?

Passive investing is a long-term approach to investment with the goal of creating wealth gradually over time. By minimising the buying and selling of securities, passive investing increases long-term gains through saving on costs.

Proponents of a passive investment strategy believe that, over time, the market will post positive results. They are not interested in profiting from short-term market fluctuations, but instead look to enter a position and hold it over longer periods of time - a strategy sometimes referred to as “buy and hold”.

We may identify someone who buys shares in one or several companies and proceeds to hold onto them for the long-term as a passive investor. However, generally when people speak of passive investing, they are referring to the action of buying shares in a fund which tracks the performance of a group of companies, a stock index, an industry or an economy.

Index funds in particular have increasingly grown in popularity in recent years as more investors come to the realisation that it is very difficult, or perhaps impossible, to consistently outperform the market.

What Is Active Investing?

It would not make much sense to write an article about passive investing without mentioning its adversary and comparing the two.

Active investing takes a more hands on approach to investment and is all about trying to outperform the market. Active investing involves ongoing buying and selling of securities, which requires constant analysis to ensure moves are timed to perfection.

Unlike passive investors, active investors pay close attention to short-term market movements and, if a security which they hold shows signs of dropping in value, they are likely to unload it as soon as possible, as opposed to trying to ride out a downturn.

Investors who prefer this style of investing may choose to buy shares in a fund which is actively managed. Such funds employ managers to monitor the fund’s portfolio and take decisions on which securities to buy and sell and, just as importantly, when to do so. 

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Active vs Passive Investing

So which is best - active investing or passive investing? This is a question which you will need to answer early on, because it will play an important role in how you invest your capital.

Unfortunately - as with many things in the investment world, and in life for that matter - there is no definitive answer as to which is “best”. 

Both active and passive investing come with their own list of advantages and disadvantages and, at the end of the day, the decision will come down to personal investment style and preference.

In the following sections, we will take a look at some of the benefits and drawbacks of passive investing, before looking at some of the options available to those who wish to pursue a passive investment strategy.

Benefits of Passive Investing

Low Fees

Passive investing is associated with lower fees than its active counterpart. This is for two reasons. Firstly, as there are less transactions taking place, fewer transaction costs are incurred. 

Secondly, and more importantly, passive investment funds do not need to pay high salaried managers and teams of analysts to research and pick stocks, meaning that passively managed funds have much lower management fees for investors.

Tax Efficiency

Another consequence of fewer transactions is that passively managed funds are very tax efficient. 

This is because, whenever a security is sold, any profit is liable to capital gains tax, which is borne by the members of the fund. Because passively managed funds buy and sell securities infrequently, there is less of this tax incurred when compared with one which is actively managed.

Many markets have another tax; a stamp duty charged on transactions. In the UK, for example, share purchases attract a stamp duty charge of 0.5%.

Outperforming the Market Is Not Easy

This would perhaps be more accurately described as a disadvantage of active investment rather than an advantage of passive investment, but it is an important point to consider.

Whilst an actively managed fund may be able to outperform the market on a short-term basis, it is very difficult to replicate this feat over a sustained period of time. 

At the end of 2015, the S&P Dow Jones Indices released a report which measured the performance of actively managed European equity funds against the performance of their benchmark indices over one, three, five and ten year investment periods.

The results are a fairly scathing assessment of the long term prospects of investing in an actively managed fund. Overall, 80% of actively managed euro denominated funds were outperformed by benchmark indices over a five year period. This figure rose to 86% over the ten year period. This example illustrates the difficulty of successfully and continuously outperforming the market.

On the other hand, passive funds, instead of taking on the seemingly futile challenge of beating the market, seek only to replicate the performance of their benchmark index. It does this by investing in the securities which make up the underlying index. For example, an index fund which tracks the FTSE100 will own shares in all the companies which are included in the index.

Disadvantages of Passive Investing

Lack of Flexibility

The nature of passive investing means that there is a lack of flexibility in the way that the fund can be operated.

For example, as we explained above, an index fund tracks an underlying stock index and it achieves this by holding shares in all the constituent companies of the index. It buys the shares and it holds them no matter what happens to the market in the meantime. 

In other words, if one of the fund’s holdings falls in value or there is information available to suggest that such a fall is imminent, the fund is stuck holding onto it, as long as the security in question remains a part of the underlying index.

In scenarios like the above, as well as being able to sell such securities, an active fund is also free to hedge their position using short sales or put options - a technique that is designed to minimise potential losses. Passive funds will not engage in this activity, they merely continue to hold the securities which are in its underlying index.

Lower Potential Returns

The italics in the above heading are important. Passively managed investment funds have lower potential returns than an actively managed one. 

Passive funds track the value of a benchmark index and will very rarely, if ever, beat the index. In fact, in reality, the return is usually slightly lower due to management fees. On the other hand, an actively managed fund can bring larger rewards. 

Whilst the percentage of active funds which outperform the market may be low, the fact remains that there are some which do successfully achieve it. So perhaps the statistics quoted earlier are not necessarily an argument against active investment funds, but rather an illustration of how important it is to do your research and pick the right one.

Of course, as with all investments, this increase in potential reward comes with an increase in risk as well, highlighting the importance of practicing good risk management techniques when investing.

Mutual Funds and ETFs

Now we are fully aware of what passive investing is and where its strengths and weaknesses lie, we will look briefly at two of the most popular passive investment vehicles; mutual funds and Exchange-Traded Funds (ETFs).

Both types of funds pool investors money in order to purchase a portfolio of securities, however, the way in which they operate is different. ETFs, as the full name suggests, are listed on stock exchanges, where their shares are bought and sold through a broker, much like shares in a company. 

This means that shares in ETFs can be freely traded during the opening hours of the relevant exchange. It also means that their share price fluctuates throughout the trading day.

Shares in mutual funds, on the other hand, are purchased from the company which manages the fund, either directly or through a brokerage firm. The share price of a mutual fund is fixed at the end of each trading day and it is at this price which investors enter or exit the fund.

Therefore, people who prefer a more “hands on” approach to investing are likely to be more drawn towards ETFs due to the ability to buy and sell shares throughout the day as and when they see fit. 

For a more in depth explanation of the differences between ETFs and mutual funds, you might want to read our article “ETF vs Mutual Fund: What Is the Difference”.

Investing in ETFs With Admirals

If reading this article has inspired you to add some passive investments to your portfolio, you will be glad to know that with Admirals you can invest in over 200 different ETFs!

In order to start buying ETFs with Admirals, you will need to follow these steps:

1. Register with Admirals and apply for an Invest.MT5 account

2. Download the MetaTrader 5 trading platform and log in using your account details

3. Head to the ‘Market Window’ tab on the left hand side of the screen and search for the ETF you wish to invest in

MetaTrader 5 market watch

Depicted: Admirals MetaTrader 5 - Market Watch

4.  Right click on the ETF symbol and select ‘Chart Window’ to open its price chart

Vanguard FTSE250 ETF ChartDepicted: Admirals MetaTrader 5 - Vanguard FTSE 250 UCITS ETF (VMID) Daily Chart. Date Range: 11 February 2020 - 22 April 2021. Date Captured: 22 April 2021. Past performance is not necessarily an indication of future performance.

5. Click on ‘New Order’ at the top of the screen to bring up the Order window shown below. Here you can fill out the required volume of your purchase (i.e. number of shares in the ETF) as well as set a stop loss and take profit if desired

FTSE250 ETF New OrderDepicted: Admirals MetaTrader 5 - VMID - New Order. Date Captured: 22 April 2021.

About Admirals

Admirals is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world's most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

Roberto Rivero
Roberto Rivero
Financial Writer, Admirals, London

Roberto spent 11 years designing trading and decision-making systems for traders and fund managers and a further 13 years at S&P, working with professional investors. He has a BSc in Economics and an MBA and has been an active investor since the mid-1990s