“The wise investor recognizes that success is a process of continually seeking answers to new questions.” Sir John Templeton, the British investor.
The roots of passive investing originated in 1970 with the creation of the first index fund. In addition, passive investing is traditionally not driven by market timing or price discovery but rather by buying a basket of stocks within your selected category- the stock market or any other industry. It’s more like the phrase slow and steady wins the race because once you purchase the basket of stocks, the essence of passive investment is to hold the stocks and prevent any interference in that.
Furthermore, in recent years, passive investment strategies such as factor investment have gained momentum due to their higher excess returns while managing a distance and low relation to the market. This element has accelerated the success of passive investment strategies, specifically rule-based strategies.
In 2019, passive investing outperformed active investing in the ratio of quantity invested. Moreover, for active investors, the ability to maintain higher returns against the market has become challenging.
Passive investment aims to target and strategically capture a specific industry or the stock market. These stocks are adhered to for an extended period.
The introduction of the first index fund in 1970 inaugurated the concept of passive investment. Since then, multiple indices have been unleashed. According to the Index Industry Association, more than 2.96 million indices are operating successfully globally.
Nevertheless, the main disadvantage of indices is that they are incredibly passive. As per Carosa, owing to the refresh rates and simplified goals, investors miss out on opportunities in the money market. The upcoming passive investment strategies allow investors to diversify and reduce risk amidst market fluctuations.
Two of the standard passive strategies are factor investing and alternative risk premia.
Let’s Unmask Factor Investment
The properties of securities that demonstrate the possibility of potential returns are known as factors. However, the value of factors is not easily identified as they are constructed and defined by ‘historical’ observations. Furthermore, three factors exist: macroeconomic, fundamental, and statistical.
The first category—the macroeconomic factor—incorporates economic growth, inflation, and interest rates. Conversely, the second category has become mainstream in recent times since the focal point of this strategy is to capture stocks and their characteristics, such as valuation ratios and technical indicators. Nonetheless, the remaining category determines characteristics by employing analytics to minimize an extensive set of variables to a relatively more minor group that encompasses information of the broader set.
After the global financial crisis of 2008, there was a demand for an unparalleled investment strategy independent from market fluctuations. Why? This strategy necessitated the processing of large data sets, resulting in complications in the pre-technology era. Furthermore, factor investment had been practiced for decades but gained ground after technological advancements.
In the latter times, efficient computer power accelerated the factor investment and made it more accessible.
Another strategy, risk premia, became prevalent. It is systematic and rule-based. The significant difference between both strategies is that factor investing centralizes long positions. On the other hand, risk premia focuses on the intervention of short and long positions.
Pros and Cons of Passive Investing
Pros
- Lower maintenance: In passive investment, you are free from consistently monitoring performance, which consumes half of your time and energy. As a passive investor, you are not bound to track your portfolio religiously since it’s a long haul; it’s more like enjoying a long car ride.
- Steady returns: According to Morningstar, passive investments outperform active funds for longer periods of time. Only 25% of active returns in the last decade beat passive returns.
- Lower fees: No need to actively buy or sell in passive investment.
Instead, this strategy encourages long-term plans but with lower expenses.
- Lower capital gains taxes: each time you sell shares to gain profit, you are prone to pay capital gain taxes, but in the case of passive investments, since you hold the assets for a more extended period, it requires less involvement in tax payments.
- Lower Risk: A great benefit of passive investment is the lower risk. In this kind of investment, you invest in an extensive mixture of assets rather than a single stock. Furthermore, passive investment stimulates a diversified portfolio.
Cons
Limited investment options: Since you don’t own fundamental equities when you invest in index funds, exchange-traded funds, or ETFs, you cannot select each investment or remove firms you believe are unworthy.
You may not get above-market profits because you aim to equal the market’s median.
Passive Investing Strategies
Any returns are yours as a fund investor. Being a passive investor may be done in a variety of ways. You can purchase index funds and ETFs in two primary methods. Both are varieties of mutual funds, which are investments that employ investor money to buy various assets.
Passive investing may assist you in diversifying so that even if one asset in your portfolio experiences a recession, it would not significantly impact your overall portfolio since index funds and ETFs allow you to participate in investments from other sectors.
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