What is passive investing?
Passive investing typically refers to the practice of buying a broadly diversified, low-cost portfolio — usually one designed to track a market index or benchmark — and sticking to it over time. This strategy — leave your money alone in a low-fee, market-tracking portfolio and do your best to ignore the inevitable ups and downs — has historically provided attractive long-term growth.
The approach is grounded in the belief that markets are generally efficient — meaning most available information is already priced into securities — so consistently “beating the market” through active trading is extremely difficult. Instead, by owning the entire market and minimizing fees, passive investors aim to capture overall market returns.
It's not just a theory, either; there is a significant body of research showing that this passive approach has, over time, done better than the majority of active investors attempting to outperform the overall market.
Passive vs. active investing
If passive investment is about letting your money follow broader market movements, active investment involves a lot more futzing: market forecasts, frequent trades, and attempts to gain an edge over other investors.
There are three main factors that make passive investing a particularly appealing alternative to active investing: fees, long-term market performance, and tax efficiency.
Fees
For decades, many investors built portfolios using actively managed mutual funds — funds run by professionals who buy and sell securities in an attempt to beat the market. These professionals don’t work for free: they’re supported by teams of researchers, analysts, and traders, and the cost of these teams is passed on to investors in the form of management expense ratios (MERs).
MERs are expressed as a percentage. While the percentage might look quite small, like 1-2%, it’s important to understand how it’s shaved off the value of the entire fund annually — whether or not the fund made or lost money.
Fees add up, especially when you understand that MERs don’t even cover the whole fee picture, which also includes trading costs (how much the fund pays to trade one investment for another). Some funds will also charge front or back end “loads,” a fancy term for sales commissions. Paying high fees can materially change long-term investment outcomes.
Performance
High fees might be justified if the fund managers were doing such an outstanding job that they were able to make up their fees with returns well above their benchmarks. But it doesn’t usually work out that way. Research consistently demonstrates that actively managed funds usually fail to outperform passive investments over the long term.
Tax efficiency
One often overlooked perk of passive investing is the tax advantages enjoyed by investors. Capital gains taxes are assessed whenever investments are sold for more than their purchase price.
Actively managed funds tend to buy and sell more frequently, which could trigger capital gains. Passive strategies trade less often, which means fewer taxable events. For exchange-traded funds (ETFs), trades usually happen between investors on the stock exchange, so the fund itself doesn’t need to buy or sell its underlying investments — again, fewer taxable events. In contrast, when investors buy or sell mutual fund units, they’re transacting directly with the fund, which may trigger buying or selling inside the fund and lead to taxable activity.
How does passive investing work?
If you believe that passive investing may be the strategy for you, securities such as ETFs could be a solution worth exploring. ETFs are basically investment wrappers that allow you to buy a large basket of individual stocks or bonds in one purchase. These funds often track an index, such as the S&P 500 or the TSX Composite, and are traded throughout the day just like individual stocks.
ETFs typically have much lower MERs than actively managed mutual funds — usually between 0.05% and 0.25%. This is because these funds are largely rules-based strategies that replicate an index rather than being managed by teams of expensive managers. Index mutual funds offer similar benefits with slightly different structures that are priced once per day, rather than traded throughout the day.
This behind-the-scenes maintenance is handled by the ETF provider, requiring no action from individual investors. It's yet another way ETFs simplify the passive investing approach. You don't need to worry about adjusting individual holdings to maintain proper market exposure, as the ETF does this work for you.
The technology behind ETFs may be sophisticated, but they're incredibly simple to purchase. All you need is an account at an online discount brokerage, funds to invest, and a decision about which ETFs to buy.
While ETFs that mirror broad market indices are the most popular, there are also more specialized options, including leveraged ETFs, inverse ETFs, and actively managed ETFs (which have higher associated fees). Caution is warranted when using any of the latter options.
Passive investing strategies
However you decide to invest your money, there are three cardinal rules that should never be forgotten: diversify, diversify, and diversify. Proper diversification means spreading investments across different asset classes (stocks, bonds, others), geographic regions, and sectors to reduce overall risk. Diversification prevents unnecessarily large losses if one of the asset classes, country, or sector falters.
