Passive Investing: What It Is and How It Works

What is passive investing?

Ever see one of those infomercials where someone throws an onion, a few carrots and a hunk of raw meat into a contraption, pushes a button, and then proceeds to climb a mountain, lounge by a pool, and play 18 holes of golf, only to return home to find a restaurant-quality meal that the whole family scarfs down rapturously? Passive investing is a bit like the financial equivalent of that delicious meal, a set-it-and-forget it approach that involves leaving your money alone for a long period of time in an account that seeks to mirror, rather than outperform a market. The philosophical underpinning of the strategy is that if you just leave money alone in low-fee market hugging accounts and ignore any and all market ups and downs passive investments will provide fantastic investment growth. It’s not just theoretical hooey, either; there happens to be a significant body of research showing that this passive approach will in the long run provide considerably better returns over those active investments designed to outfox and outperform the overall market.

Passive versus active investing

If passive investment is about just leaving an investment alone, giving it its space to grow undisturbed, active investment involves a lot more futzing, trading frequently in hopes of gaining an edge over other investors. There are three main factors that make passive investing particularly appealing alternative to acting investing: Fees, long-term market performance and tax efficiency.

Fees

Fees are like investment vampires that survive by drinking up all your gains. Passive investing is a dependable way to put a stake through the heart of those high fees. So who unleashed these greedy undead bloodsuckers on your money, you ask? The major culprit was the mutual fund industry. For the better part of a generation the conventional wisdom was that the preferred way to build a retirement nest egg was to go to one of the giant fund providers and invest in mutual funds that would contain stocks or other investment classes.

Mutual funds are run by fund managers, highly educated eggheads who wake up every day and trade the contents of the fund based on whether they foresee the value of the fund’s investments going up or down. These fund managers don’t work for free. They have assistants and the company has to spend money marketing the funds with glossy fund pamphlets and there’s an army of guys who get paid every time an office copy machine breaks down. All of these fund-related expenses are passed directly on to the mutual fund investors in the form of management expense ratios, or MERs. MERs are expressed as a percentage, one that might look quite small, like 1 or 2 percent, but it’s important to understand this percentage is shaved off the value of the entire fund annually whether or not the fund made or lost money. They add up–way up– especially when you understand that MER’s don’t even cover the whole fee picture that 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.

Performance

Any fee would 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, or the average return of similar investments. But it doesn’t usually work out that way. Studies have shown over and over again, fees are directly predictive of returns; the higher the fees, the lower the returns. Research consistently demonstrates that actively managed funds by and large fail to outperform passive investments over the long term. Vanguard, one of the pioneers of passive investing, demonstrates here how a 2% MER over 25 years can shave $170,000 off of the gains of a hypothetical $100,000 investment. For those who want to go deep, Vanguard’s much-updated landmark 2004 study on low-cost indexing makes a highly persuasive case for passive management. Even Warren Buffett, who became one of the richest men in the world by picking specific companies and stocks to invest in, has spent the last decades discouraging pretty much everyone not named Warren Buffet from trying to make money through active investment and has long publicly encouraged his heirsto invest the lion’s share of their inheritance in low-fee, highly diversified stock funds when he’s gone. Naturally, the only thing we have to go on are historical stock market returns; any stock market investment is speculative and there’s always a chance you lose a good bit of your investment.

Tax efficiency

One of the more overlooked perks of passive investing are the tax advantages enjoyed by investors. Capital gains taxes are assessed whenever investments are sold for more than their purchase price, so in an active fund where more trading takes place, it’s natural that more capital gains taxes will be assessed, thereby further eroding gains.

How does passive investing work?

If anything discussed above convinces you that passive investing may be the investment strategy you crave, you might consider joining what’s become nothing less than a movement, one you can easily join by purchasing exchange traded funds, or ETFs. ETFs are basically investment wrappers that allow you buy a large basket of individual stocks or bonds in one purchase, and unlike mutual funds, which are priced just once a day, ETFs can be bought and sold during the entire trading day just like individual stocks. ETFs have MERs that are a small fraction of those of mutual funds, between 0.05% and 0.25% is the normal range. This is because these funds are largely unmanaged by expensive humans. Instead, ETFs are programmed with an algorithm that simply track an entire economic sector or index, like the S&P 500 or the US bond market. So when, for example, Apple’s stock rises relative to other S&P 500 stocks, the algorithm will naturally calibrate the ETF so that Apple stock remains proportionally larger to other index stocks, just as it is in the S&P 500.

The technology behind ETFs may be high tech, but they’re incredibly simple to buy. All you’ll need is to open an account at an online discount brokerage, a process which will take you all of 10 minutes. If you suspect that you’ll need a bit of hand holding in terms of what you’d like to purchase, you might consider investing with an automated investing service which will recommend a mix of ETFs tailored to your particular financial situation and goals.

Though ETFs that mirror indices like the stock or bond market are by far the most popular, a number of more complicated funds like leveraged ETFs and inverse exchange-traded funds. Unless you absolutely know what you’re doing and would, say, be able to explain how derivatives work to a third grader, you should avoid these ETFs like you would poison ivy at a picnic. Don’t be afraid of spiders, however. Spiders are simply how many refer to Standard and Poor’s Depositary Receipts (SPDR), some of the very first ETFs. The SPDR S&P 500, in fact, was the largest ETF in the world for many years.

Passive real estate investing

Though it’s become a calcified kernel of wisdom over the years that home ownership is the best investment a person could ever make, those who’ve actually run the renting versus buying numbers have largely concluded that more money can be made renting and investing what you save in equities rather than buying a house. (Any homeowner whose basement has ever flooded has uttered the words: “Why the %$&* couldn’t I just have rented?”) But there is a way to invest passively in real estate without ever having to worry about having to replace a leaky toilet — REIT ETFs. REITS are real estate investment trusts, companies that sell shares in their various real estate investments. As with any investment, diversifying is of paramount importance, so by buying a REIT ETF rather than shares in a single REIT, for one price, you could buy slivers of dozens or even hundreds of REITs. There are literally hundreds to choose from and REITs offer some major tax benefits you won’t find elsewhere, they’ve become a particularly popular investment for the super rich.

Passive investing strategies

However you invest your money, be it using active or passive strategies, there are three cardinal investment rules that you must never forget: diversify, diversity, and…diversify! By purchasing ETFs, you’re naturally diversifying within one sector, be it stocks, bonds or even marijuana, a high growth area in the ETF racket. But you also must diversify among sectors and even countries’ economies. How you invest passively will certainly depend on your goals, risk tolerance, and the time horizon of your investment; those with decades long time horizons and high risk tolerance will likely have a larger percentage of their passive investments in US and foreign equities, with only a little invested in stable, but low return investments like government bonds. An imperfect rule of thumb has been that you should subtract your age from 100, and invest that percentage in stocks, so a 30 year old would be 70% invested in stocks. This kind of diversifying within a passive portfolio prevents unnecessarily large losses if one financial sector or even a country’s economy falters. This guide will offer solid advice on diversifying.

At Wealthsimple, we happen to think that a diversified, low-cost portfolio of passive investments is the key to a solid financial future. Why not start investing with Wealthsimple today?We offer state of the art technology, low fees and the kind of personalized, friendly service you might have not thought imaginable from an automated investing service. Sign up now or learn more about our free portfolio review.

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