Exchange-traded funds (ETF’s) have been around since the early 1990s. And ever since ETFs have been around, the idea of investing in ETF’s have been interchangeable with Passive investing, but in reality- passive investing still has an active component.
Passive investing is where you buy a portfolio of assets that replicate a certain index, say the NZX50 or S&P500, or any other fund that is not actively managed by fund managers. Basically, there is no one at the helm making decisions about where the money is invested. The rules for the fund are set out before the fund is started- for example, the fund will try to provide a return that closely matches the return of the NZX50 by invests in financial products listed on the NXZ50.
The alternative to passive investing is actively investing. Where you invest your money with a fund manager or directly and try to beat the return of the market by actively selecting which companies to invest in. To try and beat the market, an active fund manager will need to have a team of analysts to pick the companies to invest in. This means that an active fund is more expensive to run, and hence the higher fees.
The problem is that there is a body of evidence that shows the average active managed funds doesn’t beat the market in the long term.
Passive investing has become extremely popular because of this fact, and that the fees are generally lower than actively managed funds. Fees are the one guaranteed when it comes to investing, as returns are not guaranteed. So it makes sense to choose the lowest fees you can. I’ve shown before what the difference is between investing $10,000 at a 0.2% fee fund compared to a 2% fee over 40 years. And the difference is huge! $100,608 to be exact.
There are other reasons that passive ETFs have become popular in recent years;
- They generally have better performance than actively managed funds. There are now decades of data that proves most active fund managers fail to beat the market in the long term. And if you do find a fund that does beat the market in the long term, remember that this may be due to survivor bias.
- Passive funds are low cost compared to actively managed funds, saving you thousands in the long term
- Passive funds are easier to understand as you know that they are doing at any given time- trying to mimic the index that they are mirroring. There are no surprises.
- Passive funds are liquid. meaning that because you can trade them on a stock exchange, you can sell shares in passive funds relatively quickly.
- Passive fund offer diversification over investing in the share market yourself and some passive funds are more diverse than actively managed funds.
Active investing with Passive Funds
The caveat is that there is a component of active investing with passive funds. Investing in passive ETFs does not stop you from making active decisions. Especially now, where there are so many different passively run ETFs around.
The first ETF was launched in 1993. The market grew to around 100 funds in 2002 and continued to grow to over 1000 funds by 2009. And now there are over 5000 ETFs to choose from.
So the first active decision with passive funds is not made by you, the investor. Its made by the fund creator. Originally, a passive fund was developed to follow one core stratory- to be exposed to the entire market so they would track an index.
The range of funds then went through an evolution where they moved from just being exposed to a market index to being actively designed to follow other specific rules. They might be actively designed to be exposed to niche sectors, overweighted in certain sectors, be country specific, or exclude certain countries. There are almost limitless ways that an ETF can be actively developed.
Active Asset Allocation
The second active decision that needs to be made with passive funds is your strategic asset allocation. This sets out a model that you want to follow over the long term to create your portfolio based on your investment horizon and investor style.
It’s generally advised that you split your investments over a certain mix of investment types. The main investment available types are cash, bonds, property, and shares. You need to actively decide what type of investment you are going to invest in.
You can use tools to determine what type of investor you are and what allocation might be right for you. For example, if you are a growth invest then it’s advised that you have 4% of your investments in Cash, 26% in bonds, 10% in property, and 60% in shares (a mix of global and local).
Whatever you decide you want your asset mix to be you can use ETFs to generate your portfolio actively. There are bond ETFs, there are Cash ETFs, there are property ETFs, and there are obviously share ETFs.
My current portfolio has been actively selected- although it seems random, using a number of different ETFs (and strictly speaking, some are managed funds), alongside some peer to peer lending.
Dynamic Asset Allocation
So you have made the first active decision with passive funds, and that is which passive funds you want to invest in. There is another active component of passive fund investing. That is your asset allocation over time.
Your asset allocation over time will need to be actively managed over time- rebalanced. Portfolio rebalancing is where you actively realign the weightings of your portfolio of assets. It involves periodically buying or selling assets in your portfolio to maintain your original or desired level of asset allocation.
The second active decision over time is how your portfolio asset allocation changes over time. When you are young you should have more growth assets, and over time, when you get closer to retirement age, you should move away from high growth high-risk assets in favour of less volatile assets as you may be reliant on drawing down on your investment portfolio in retirement.
Passive Investing Summary
ETFs offer a very convenient and affordable passive investment that exposes you to a huge range of markets. But some analysts believe that they are to blame for as a source of additional volatility in the markets. This idea is unlikely to slow their growth, though, and it seems probable that the importance and popularity of these investments funds are only going to grow in the coming decades.
It’s important to know that there are active components of investing in Passive funds. This might not be as clear to newer investors as it is with more seasoned investors. The passive component comes from the fact that the fund is making less active decisions in how it operates. But your investment portfolio should be actively managed.
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This is a great article for a newbie with a side Vanguard account like me. My husband and I have our work accounts more actively managed (I especially don’t get a choice). When it comes to Vanguard, I’m continually prompted to add some bonds to the mix but it’s really our call.
The fact you have about the difference of .2% and 2% after 40 years is astounding! I need to show this to my parents and my husbands parents. They are the ones being eaten alive!
Thank you for your kind words! The difference between 0.2% and 2% over 40 years astounds me every time I look at it!