Passives have some advantages over active investing. One of these is cost – you can build a diversified portfolio of passives relatively cheaply.
They also remove some selection headaches that can be associated with active funds. You simply choose a market and buy a passive vehicle that replicates that market. This has the advantage of simplicity. You know what you are getting and you can potentially gain access to the performance of hundreds of stocks, depending on which index you track. There is also little risk of underperforming the market – safety in numbers.
What is required is education. While an ever more diversified set of investors have a better understanding of – and a positive stance towards – passives across asset classes and geographies, there is work to be done to increase awareness.
Passive providers such as BlackRock and ETF Securities see part of their role as educating investors about the concepts of passive investing and understanding the markets, rather than simply selling products.
Another trend is the increasing use of ETFs as core portfolio building blocks. Many investors are using low-cost ETFs for their exposure to major markets, then adding some active investments around them to add alpha.
Do passive investments, in ignoring the needle in the haystack by buying the stack itself, give up the moral high ground?
A passive fund that tracks a particular index holds all the companies in that index – good and bad. Active managers are more discerning and only buy companies they think will survive and outperform. They actively shun weak companies and those with poor corporate governance. By investing in passive, you are giving up some moral high ground by investing in everything in that index.
In a bull market, which we have enjoyed since March 2009, passives track the market that appeals to investors. In a bear market passives feel the full brunt of falling markets. In general, active managers have the ability to mitigate some of the potential losses and this is when they can really come to the fore.
Adopting a passive investment approach does not prevent you from making bad decisions.
One of the problems for investors is emotions getting in the way. Passive investing does not prevent mistakes such as buying high and selling low, or putting all your eggs in one basket.
Not all passive funds are cheap, so be careful when selecting funds and check the fees.
How do you decide which index or indices you want to buy? Asset allocation remains a key diversifying skill. In 2015, the FTSE All-Share index returned 1 per cent, while the FTSE 250 achieved 11 per cent. An active decision on asset allocation is still required.
Are you experienced and sufficiently qualified to make the decision on which index to invest in? How do you go about monitoring and rebalancing your portfolio? All this means you still need to take an active investment approach to manage your passive portfolio, although an approach such as that taken by Vanguard, BlackRock and several others, where the asset allocation is done for you, could be appropriate for some investors.
Passive investing is not a panacea, just a different way of accessing underlying investments. Whether you go down the active or passive route, good investing tactics such as adopting a long-term time horizon and ensuring your portfolio is sufficiently diversified are crucial. Once you have decided where you want to invest, gaining cheap access to markets via passives is a sensible approach. Adding some active investments at the edges could be a way of building the optimum portfolio to meet your investment needs.
Michelle McGrade is chief investment officer at TD Direct Investing
