The positive side of being passive

Passive investing is a term often used to describe the investment approach of taking a broad, whole-of-market-level investment, without 'actively' looking for winners or avoiding losing investments. This 'passive' approach seeks to benefit from being 'in the market' but without worrying too much about 'beating' the market.

So that's a lot of 'quotations'! But really the fundamental concept comes back to capturing those markets, whether shares or bonds, property or commodities, or many others, as simply as possible. This often relies on market indices, or Index Investing, in order to do this. but to properly understand why you might take this approach, it is worth taking some time to understand what a market index is and how it is used in modern investing.

Whether you are familiar with financial terminology or not, you will possibly already have heard of some of the more famous indices without even realising what they are. The original and arguably the most well known is the Dow Jones Industrial Average. Way back in 1896, a stock market investor by the name of Charles Dow wanted a quick and easy indicator of how the US Stock Market was going, if not as a whole, then at least capturing the biggest names of the day. This index was a very basic number, created simply from a dozen companies and averaging their share prices. If those chosen companies went up in price, then so did the index. A very crude measure of a stock market, but easy to calculate in an era before computers.

Modern indices are usually a bit more thorough in their construction, and the most popular method nowadays is market capitalisation weighted. That is, the bigger the company (as measured by number of shares on issue multiplied by their current price), the bigger their weighting in the Index. Market Cap indexes like the S&P 500 or the NASDAQ 100 in the United States, or the All Ordinaries Index in Australia, are big name examples of this style of indexing.

S&P Dow Jones.jpg

Now an index is just a number, it isn't actually the market, but it is the closest thing we often have to knowing all of what the market is doing from moment to moment, day to day. As an investor indices can form two very helpful functions.

Firstly, it is a measure of how well your money is being invested, it can be a benchmark. For example, the S&P/ASX 200 tracks the performance of the top 200 biggest (by market cap, or size) Australian listed companies. If you as a share investor, or the fund manager who is investing on your behalf, are investing in this Australian share market, you might consider that getting at least as good as the share market as a whole (as defined as this index) to be your minimum standard. Why? Because you could theoretically go out and copy the index by buying what makes up the index in the same amounts (proportionately), so if you are going to invest differently to the index, you want to do better.

Finally, this leads us to the idea of passive investing. If we have this minimum standard of an index as the benchmark, maybe we don't want the hassle and expense of trying to do better, maybe we are perfectly happy with just getting 'the market'. Now you could always go through the effort of buying each of the individual shares that make up an index, all in the right proportional amounts; however we are lucky enough that now days there are many, very affordable alternatives to doing this.

Enter the Index Fund Manager. These fund managers, just like their active, beat-the-market colleagues, build portfolios to match as closely as humanly possible a given index, and then bundle these portfolios up and sell them as managed funds. Pioneered by groups like Vanguard Investments in the US decades ago, there are now many hundreds of fund managers (and thousands of funds) that operate this way.

Even better, they now have these index funds, packaged up and ready to invest in, selling on the same Stock Exchanges as the underlying shares they cover. These tradeable, ready-made investment portfolios are called Exchange Traded Funds, or ETFs, and are massively popular and growing more so every day.

So why would an investor want to "passively' invest and just accept these 'dumb' market returns? Don't we want to 'beat the market', pick the winners and avoid the losers? Well, unfortunately, that's not as easy as it sounds. Although plenty try to do just this, even the professionals it turns out aren't that fantastic at the task.

This from Standard and Poors in their latest SPIVA scorecard that analyses the efforts of the Australian managed fund industry.

There is no consistent trend in the yearly active versus index figures, but we have consistently observed that the majority of Australian active funds in most categories fail to beat the comparable benchmark indices over three- and five-year horizons. As of June 2016, the majority of Australian funds in all categories, except the Australian mid-and small-cap fund category, were outperformed by their respective benchmarks over the one-, three-, and five-year periods. International equity, Australian bond, and A-REIT funds significantly underperformed their respective benchmark indices over the one-,three, and five-year periods.
— SPIVA Australia Scorecard Mid-Year 2016


A lot of this under-performance has been blamed on the high active fees charged by some managers. Many managers charge in excess of 1% per year, which means their investment choices need to do better than the market index by at least 1% to just break even. Not as easy as it might sound.

As a solution, many investors have turned to index investing in some or all of their investment portfolios. Because index investing is a lot easier than trying to pick the winners and avoid the losers, with less trading and overall lower costs, these types are much cheaper to run, some fees approaching a tenth or even less than their active market competitors.

With long term share markets returning 8% to 12% historically, and active managers struggling to consistently beat the market by more than even 1%, why not go after just the 'market returns'? Add to this the explosion of ETF offerings coming cheaply to the market, very easily traded each day online, you can quickly see why Passive investing is the 'new black' of investing.