Passive investing strategy insights
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Interest in passive investing has exploded around the world as investors begin to understand the benefits of investing in a low cost, globally diversified portfolio of funds that track the market.
Passive investing has grown in popularity around the world for decades now, but Canadian investors have been slower to adopt the approach. While passive investment strategies now make up more than 50% of assets in the United States, that number is closer to 10% in Canada.
Okay, we’re a little slow on the uptake. But there’s reason to believe that passive investing is about to take off in Canada. In 2018, more money flowed into Canadian-listed ETFs (which are mostly passive) than into active funds for the first time in 10 years.
This article will explain what passive investing is about, what income can be derived from passive strategies, the difference between active and passive investing, plus look at a recent argument that passive investing is in a bubble.
What is passive investing?
Passive investing is a strategy that aims to remove any decision-making or judgment about what an investor buys or sells, and when an investor buys and sells it. Instead, a passive investor simply buys a basket of securities that tracks a particular index. That index may impose a number of quantitative rules and then make all of its “decisions” based on those rules. The investor “passively” follows the index and so his or her returns closely mirror the results of that benchmark.
The easiest way to invest passively is to buy an index mutual fund or ETF that tracks a specific market index, such as the S&P 500. An ETF that’s tracking the S&P 500 would hold the exact same securities as its benchmark index.
Active vs. passive investing
There is no universal case for passive investing, as not all indexes are diversified and low cost, while not all active funds are high cost and concentrated. But an overwhelming amount of academic research shows, however, that active managers cannot consistently pick winning investments over time. The theory behind passive investing is that investors are better off buying a market-tracking index (through an index mutual fund or ETF) and accepting market returns.
As it turns out, that theory works great in practice. According to the 2019 SPIVA Canada Scorecard report, more than 75% of Canadian equity fund managers failed to beat the S&P/TSX composite index benchmark in 2018. The results get worse over time for active managers. More than nine in every ten funds underperformed their respective benchmark over the 10-year period.
Passive investors look to match market returns as cheaply as possible by:
- Buying index funds or ETFs that track a broad-based market index
- Diversifying their investments across the globe
- Simplifying the investment process and minimizing buying and selling, and avoiding market timing
Active investors aim to beat the market by:
- Picking the best-performing stocks and avoiding the worst performers.
- Using strategies such as momentum or swing trading to time the market and catch a rising stock
- Focusing on high-growth stocks (Facebook, Amazon, Alphabet, Netflix) or dividend-paying stocks (dividend aristocrats)
Most active strategies can be back-tested to show outperformance in some way, shape or form. One famous example comes from Bill Miller, an all-star fund manager at Legg Mason who beat the stock market every year from 1991 to 2005. Miller then went on to get trounced by the S&P 500 over the next four years, where a $10,000 investment in his fund at the end of 2006 shrank to just $4,815 by the end of 2011.
Then there’s Warren Buffett’s famous $1 million bet with hedge-fund manager Ted Seides that a simple S&P 500 index fund would outperform a basket of at least five actively managed hedge funds over the course of a decade (2007-2017). Buffett’s bet on indexing paid off, as the S&P 500 delivered annualized returns of 7.1% while the hedge funds returned just 2.2% per year.
How to invest passively
A passive investor takes a simple, low-cost, globally-diversified approach to their investments. They choose an appropriate asset allocation between stocks and bonds that aligns with their risk profile and invest with a long time horizon in mind.
You can easily set up a passive investing portfolio on your own using one of the best online brokerages in Canada. If you’d rather have a little hand-holding with the investing process, cut the fees to the barebones and go with a robo-advisor instead of a bank or traditional investment firm.
If you’re a do-it-yourself investor, it doesn’t get any easier or cheaper than opening an account at Questrade, where you can purchase commission-free ETFs. Once you’re set up you can choose from several index-tracking ETFs. I prefer the one-stop asset allocation ETFs like Vanguard’s VBAL or VGRO.
Some investors aren’t cut out for the DIY route, so a robo-advisor is a perfect platform to manage your investments online and still get some human advice when needed. Robo-advisors tend to follow passive investing strategies and build custom portfolios with several diversified index funds and ETFs.
If you’re not sure where to start, check out our Canadian robo-advisor comparison guide. But let’s cut to the chase: Canada’s leading robo-advisor (and our top pick!) is Wealthsimple, whose investment philosophy centres around passive investing. Wealthsimple uses ETFs from major fund providers such as Vanguard, iShares, and BMO to build a globally diversified portfolio of index-tracking funds.
Passive investing benefits and drawbacks
There are some big benefits to passive investing. Overall, most passive investors buy and hold for the long term and aim to achieve market returns, minus fees. Those fees tend to be a fraction of what an actively managed fund would charge.
- ✅ Cheaper to own
- ✅ Easier to implement
- ✅ Tends to outperform actively managed investments
- ❌ Limited: Passive funds are restricted to a specific index or a fixed set of investments. So, investors are stuck with these holdings, regardless of what happens on the market in a given year.
- ❌ Smaller ROI: Passive investors will never beat the market. Typically, you earn whatever the market returns before fees.
Nonetheless, the pros of passive investing are enticing, and it’s a tried, tested, and true strategy for investing.
Debunking passive investing myths
There’s a lot of “fake news” and misleading information swirling about passive investing. Let’s look at the facts.
MYTH #1: “Passive investing delivers average ROI”
Critics say that passive investing only delivers average performance and only works for average investors. Who wants to be average?
It’s true that passive investors will never beat the market – by definition the most they can earn is whatever the market returns before fees. But this is not the same thing as earning average or middle-of-the-road returns. Earning market returns actually put passive investors ahead of most active strategies.
The reason why many so-called skilled fund managers underperform their benchmarks is that investing is a zero-sum game before costs. For every dollar that outperforms the market average, there must be a corresponding dollar that underperforms the market average before costs. However, once costs are deducted, the distribution of returns shifts to the left and more than half of the assets in every market underperform the market average.
Facts:
- Passive investors earn market returns, before fees
- Active investors as a whole must underperform passive investors after fees
MYTH #2: “Passive investing only works in a bull market.”
Another passive investing myth is the idea that passive investing is only a bull market strategy. Here’s how the line of thinking goes: when returns are strong (like they have been for the past 10 years), passive investing has worked well. But when markets correct or crash, active managers will have their chance to shine and outperform – moving to defensive strategies to limit portfolio losses.
This argument sounds great in theory, but what is the probability that an active manager can consistently re-position their assets at just the right time ahead of significant market movements?
The reality is, that most significant changes in market direction are unanticipated, making them difficult to predict and capitalize on beforehand. Then when the market turns positive, the manager would need to quickly reposition their portfolios to take advantage of the upswing. Unless your fund manager is psychic, it’s highly unlikely that they’re able to be one step ahead of the market.
Since markets tend to go up more often than they go down, the most optimal strategy is to stay invested for the long term.
Facts:
- There’s no reliable way for active investors to time the market
- Markets have gone up 2 out of every 3 days, meaning investors are better off staying invested during ups and downs
Myth #3: “Passive investing is in a bubble.”
Passive investors have enjoyed a long and nearly uninterrupted bull market for the past decade following the aftermath of the global financial crisis. Michael Burry, who famously bet against the U.S. housing market before the 2008 crisis (as profiled in The Big Short), raised alarm bells recently when he suggested that we’re in a passive investing bubble.
Here’s what happened: Burry wrote in an email to Bloomberg News that as money pours into ETFs and other index-tracking products that favour large companies, smaller value stocks are being neglected around the world. Burry wrote:
“The bubble in passive investing through ETFs and index funds as well as the trend to very large size among asset managers has orphaned smaller value-type securities globally”
Of course, more than a few eyebrows get raised when a well-known contrarian fund manager calls out the passive investing movement. But should investors heed Burry’s warning and bail on their passive investments?
No! Let me explain why the ETF bubble argument is nonsense.
Burry’s primary concerns about passive investing have to do with market integrity and liquidity. ETFs are not just like stocks. They trade on an exchange like a stock, but stocks have a finite number of shares available. An ETF is an open-ended fund that can create new units based on demand. Market makers will continually offer new shares and will create new units when needed.
Just like a stock, an ETF is subject to the integrity of the markets. If there is a market event or large changes in investor sentiment, we’d expect ETFs to move with the market. ETFs are priced based on their underlying portfolios, not the other way around. The idea that ETFs impact market stability as they became more prominent doesn’t make sense.
As for liquidity, ETFs have access to the liquidity of their underlying portfolios. That means a large trade on a small ETF will not move the ETF’s market price. On the other hand, more established ETFs with high transaction volumes can have even greater liquidity than their underlying holdings.
Facts:
- ETFs are not artificially inflating the market
- ETFs are buying the market, not individual stock
The bottom line
You’ve read all about passive investing and how it compares to active investing strategies. Investing is a bit like fashion – everyone has their own idea of what works. It’s deeply personal, and each individual may need to try on a few things to find something that fits. However, passive investing is an effective strategy that’s worked for decades and the bottom line is that an overwhelming amount of academic research and empirical evidence points to passive investing as the optimal way to invest and achieve the best outcome over the long term. Don’t let the myths and misinformation about passive investing scare you from giving it a go.
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