Passive investing

Passive investing (also called passive management) is a strategy in which an investor (or a fund manager) invests in accordance with a pre-determined strategy that doesn't entail any forecasting (e.g., any use of market timing or stock picking would not qualify as passive management). The idea is to minimize investing fees and to avoid the adverse consequences of failing to correctly anticipate the future. Passive management is the opposite of active management, which typically aims to beat the market.

The most popular passive investing strategy is to mimic the performance of an externally specified index: this is known as indexing. Retail investors typically do this by buying one or more index funds or exchange-traded funds (ETFs) that track a broad market index. By tracking an index, an investment portfolio typically gets good diversification, low turnover (good for keeping down internal transaction costs), style consistency, and extremely low management fees. With low management fees, an investor in such a fund would have higher returns than a similar fund with similar investments but higher management fees and/or turnover/transaction costs.

Sharpe defines passive investing in the following manner:

In this definition, passive investing means indexing. Orthodox passive investors will select index funds or ETFs that track capitalization-weighted total market indexes. But other strategies can be considered passive, or relatively passive, such as fixed income ladders, or funds and ETFs that follow non-traditional indices or select securities by using predefined screens without human intervention. The rest of this article uses 'passive' in the 'indexing' sense.

Rationale for passive investing
The concept of passive management is counterintuitive to many investors : why settle for the return of the index (minus fees) when active management offers the possibility of "beating the market"? The reason to choose passive management is that few active investors actually manage to beat the market over the long term.

Active management's results
Canadian mutual funds with active management have a hard time beating their benchmarks over five years, as shown by the following table containing the oldest, and most recent, available periods:

Percentage of funds outperforming the index over five years, as of June 30, 2015 and June 30, 2010

Actively managed fixed income mutual funds do not have a good record of beating their benchmarks in Canada either. Over ten years as December 31, 2014, one study found that 0% of short term bond funds funds beat their benchmarks, whereas 4% of medium term bond funds did. Over five years, the figures were 2% and 4%.

The rest of this section offers both a simple explanation of why passive investing works, i.e. "costs matter", and the more complex ones of financial economics.

Explanations
The following figure sums up the main reason why passive investing works: the costs are lower. In The Four Pillars of Investing, introduction to Chapter 3 ("The Market Is Smarter Than You Are"), William Berstein provides the following humorous illustration of why active management typically fails:

"Pretend (…) you live in an obscure tropical country called "Randomovia". (…) it has one serious problem: a rampant chimpanzee population. (…) The Randomovians periodically round (the chimpanzees) up, dress them in expensive suits, place them in luxurious offices, and allow them to manage the nation’s investment pools. (…) They pick stocks by hurling (darts) at the stock page. This means three things about Randomovia: The chimps each have about a 50% chance of beating the market. There’s only one problem: The investment pools they manage charge the Randomovians 2% of assets each year in expenses. In any given year, the differences in performance are great enough that the 2% expense does not matter that much. But because of the 2% drag, instead of 50% of the chimps beating the market each year, only about 40% of them do. With the passage of time, however, the law of averages catches up with all but the luckiest chimps. After 20 years, only about one in ten beats the market by more than their 2% annual expenses. So, the odds of your picking that winning chimpanzee are … one in ten. Well, dear readers, I have very bad news. For the past several decades, financial economists have been studying the performance of all types of investment professionals, and their message is unambiguously clear: Welcome to Randomovia!"
 * Over any given period of time, some of the chimpanzees will be lucky and obtain high returns.
 * The past performance of a chimp at selecting stocks has no bearing on this future performance. Last year’s or last decade’s, winner will just as likely be a loser as a winner next time.
 * The average performance of all the chimpanzees will be the same as the market’s, since chimps are the only ones who can buy and sell.



'Figure (modified from Vanguard's publications): investing is a sum-zero game. The dollar-weighted performance of all investors (hypothetical bell curve on the right) is equal to the performance of the market. After costs, the curve is shifted to the left: few high-cost active investors beat the index every year. Low-cost index funds and ETFs have returns close to that of the index, outperforming most active investors.'

Another explanation of the comparative success of passive investing is that active managers may miss the best performing stocks in an index, and these account for a significant proportion of returns: "the entire gain in the U.S. stock-market since 1926 is attributable to only 4% of the stocks".

Financial economics
The rationale behind indexing stems from several concepts of financial economics:


 * 1) In the long term, the average investor will have an average before-costs performance equal to the market average.  Therefore the average investor will benefit more from reducing investment costs than from trying to beat the average.
 * 2) The efficient-market hypothesis postulates that equilibrium market prices fully reflect all available information, or to the extent there is some information not reflected, there is nothing that can be done to exploit that fact. It is widely interpreted as suggesting that it is impossible to systematically "beat the market" through active management, although this is not a correct interpretation of the hypothesis in its weak form. Stronger forms of the hypothesis are controversial, and there is some debatable evidence against it in its weak form too. For further information see behavioural finance.
 * 3) The principal–agent problem: an investor (the principal) who allocates money to a portfolio manager (the agent) must properly give incentives to the manager to run the portfolio in accordance with the investor's risk and return appetite, and must monitor the manager's performance.
 * 4) The capital asset pricing model (CAPM) and related portfolio separation theorems, which imply that, in equilibrium, all investors will hold a mixture of the market portfolio and a riskless asset.  That is, under suitable conditions, a fund indexed to "the market" is the only fund investors need.

Some active managers may beat the index in particular years, or even consistently over a series of years. Nevertheless the retail investor still has the problem of discerning how much of the outperformance was due to skill rather than luck, and which managers will do well in the future.

Retail investors
Passive management in the form of index funds and ETFs is on the rise. According to Morningstar, in the US, passive products grabbed “68% of net sales in the 12 months ended June 30 (2014). Active mutual funds... managed to get just 32% of net sales”. The Economist reports that “American ETFs received $895 billion of inflows between 2008 and 2013, compared with only $403 billion for actively managed mutual funds”.

According to the same article, “''One reason for the rise of ETFs is the changing behaviour of financial advisers. Historically, many earned commissions, paid by the fund-management company whose products they sold and incorporated in the annual management charge. This system created a conflict of interest: the products that were best for advisers to sell were not necessarily the best products for clients to own.''”

The popularity of passive investing in probably not as strong in Canada than in some other countries because here, most investment advisors are still compensated based on commissions. In the UK, “''the introduction of the retail distribution review (RDR) in 2013 abolished commissions and required advisers to explain the true cost of advice to clients. Slowly but steadily this will expand the market for low-cost funds.''”

Other possible reasons why more investors have not yet embraced indexing is “the nagging feeling that there’s something better out there” (elusive market-beating strategies), and a difficult to overcome resistance to simplicity.

Pension funds
Nicolas Firzli, director general of the World Pension Council, estimates that “14-16 percent of total worldwide (pension) assets are invested in passive mandates”. A survey of US institutional managers reveals that 88% “expect the market share of institutional index funds to exceed 20% in the coming three to five years”

In Canada, only 4% of defined benefit pension assets were passively managed in 2013. According to Fred Vettese (chief actuary, Morneau Shepell), the primary reason for this is that "many plan sponsors haven’t seriously considered the question".

Issues with passive investing
Passive investing works very well with Canadian bonds, US equities and International equities. There are some potential issues with applying indexing to Canadian Equities, because our stock market is influenced by a relatively small number of stocks and concentrated in a few key sectors. This is discussed in Diversification: sector concentration and index concentration and solutions are examined in Diversification strategies.