An Introduction to Passive Investing

This is part one of a two part series on passive investing. Part two is "The Globally Diversified Index Fund" (see article).

What is Passive Investing?

Passive investing is an investment strategy where the investor avoids making any active investment decisions. The strategy is passive because the investor limits the number of active investment decisions to make. A passive investor is not involved in the frequent buying or selling of investments but employs a buy and hold strategy. This strategy is not a get rich quick scheme, and there's absolutely no market timing involved.

For the average investor, this is likely to be the most suitable investment strategy.

What Is an Index?

An index tracks the underlying performance of a portfolio of assets, commonly shares in companies but are also known to track other assets such as bonds, precious metals, commodities, property or even cash.

The focus of this article is on share indices, e.g. the FTSE 100 index, which tracks the performance of the largest 100 companies (by market capitalisation) listed on the main market of the London stock exchange.

Other well-known indices are the S&P 500, which tracks the performance of the largest 500 companies in the US and the Dow Jones Industrial Average, which tracks the performance of 30 blue-chip companies deemed to be important to the US economy. The Nikkei 225 tracks the performance of 225 large listed Japanese companies.

What Is an Index Fund?

An index fund is an investment fund that aims to mirror the performance of the chosen index, such as the FTSE 100 or the S&P 500.

The investment manager raises a pool of cash from investors and uses this cash to acquire all (or a statistically significant number) of companies on an index. The goal is to mirror the performance of the specific index. Investors in the fund are known as index investors, probably the most common passive investing strategy out there.

The investments in an index fund track an index like the S&P 500 or the FTSE 100. The investment exactly mirrors the chosen index. Ignoring variables such as; fees, transaction costs and tracking error, should the S&P 500 index were to rise by 2% in any given period, the value of an investment in the fund will also increase by 2% over the same period.

There are now indices that track the performance of just about every sector, market or asset class available. Some are good. Most are not. I have previously written about the only fund you should invest in here.

Although index funds have become more complicated, there is a subsect of index funds that do not actually purchase any of the underlying assets. Instead, they track the performance of an index with financial products such as derivatives. Alternatively, big players in the index fund market, such as Vanguard are known to use a sampling method to determine which companies on the index the fund should buy.

History of Passive Investing

We can't talk about index-funds and passive investing without the mentioning the late John "Jack" Bogle a pioneer in index funds and the Godfather of passive investing.

Before founding Vanguard, Bogle was a very successful investment manager in his own rights, rising relatively quickly through the ranks at Wellington Management and ultimately becoming the chairman. However, an unsuccessful merger cost him his job.

It was this failure that was the catalyst to him starting his investment firm. Vanguard is now one of the largest investment managers on the globe and offers some of the best index funds, with very little tracking error and some of the lowest fees on the market. No, Vanguard haven't paid me to say that...

As you can imagine, when he initially came up with the idea of starting an investment fund to track an index with low fees, it wasn't at all received well. Bogle was laughed at by his peers on wall street, who did not take him seriously. They thought he had lost his mind and couldn't understand why you should settle for market returns as opposed to aiming to beat the market.

Little did they know that Bogle was pioneering a new multi-trillion dollar industry, with the return for his funds exceeding more than 90% of the active investment managers at the time.

The idea behind passive investing has been put together well by the man himself, Jack Bogle, in his book called The Little Book of Common Sense Investing. Bogle has shared his wisdom with us in this book. It's one that has positively reinforced my belief that passive investing is the best investing strategy for 99.9% of people.

Investing is really common sense, and both Warren Buffet and his long-time partner are known to say investing success is more about not being stupid consistently over the long-term than about being smart.

“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” - Charlie Munger

The Famous Warren Buffett Bet

Warren Buffett, one of the greatest ever investors repeatedly explains that 99% of investors should not even attempt to beat the market. He tells us that they would be much better off investing in a low-cost index fund.

He goes on to say that "most investors lack the time, commitment, knowledge, and discipline to succeed at active investing"; some of the characteristics required by the 1% to succeed.

You're unlikely to be part of the 1%, so competing against professional investors is a waste of your capital and time. You should stick to index investing, which has the odds massively in your favour and gives you a decent chance of success.

Then they’ll get a decent result over time. To some extent, the smarter you try to be, the worse you do in investments. Now, there’s a few professional investors that will do better than the S&P over time. But the average individual isn’t going to be able to find them. - Warren Buffet

Buffet put his money where his mouth is by, providing for over 90% of his wealth to be invested passively in index funds upon his death. If this is how the greatest investor of all time wants his wealth to be invested, you better take note. There's a reason he's worth $85bn and you're not.

Buffett also famously won a $1m bet with a group of "super smart" hedge fund managers. Buffet's side of the bet was that over ten years, a low-cost S&P 500 fund would provide higher returns than a group of highly skilled hedge fund managers.

It may sound absurd and let's not forget that these "super smart" hedge fund managers earn huge fees to beat the market for their clients. It is literally their jobs. If they're unable to beat the market over the long term consistently, investors will switch their investments from active strategies to passive strategies.

Ten years later, his fund compounded with a 7.1% annual return, compared to a 2.2% annual return for the "super smart" hedge fund managers. It wasn't even close. Not so "super smart" after all?

The results are despite the fact his investment initially suffered a considerable loss as a result of the 2008 market crash. This was the biggest crash for the S&P 500 since the great depression. The hedge fund guys would have been brushing each other's egos at this point.

Throughout these ten years, the hedge fund managers would have been spending hours researching potential investments, rebalancing their portfolios, executing the trade, up all night anxious and worrying about their positions etc. On the other hand, Buffett made his investment, forgot about it, then woke up pleasantly surprised ten years later. Being lazy when it comes to investments is what is rewarded and not hard work.

A big reason for the hedge funds losing the bet was their frequent trading - it's costly. Besides, the substantial management fees they were charging eats into the investors' returns. Fees are much lower for passive funds as there isn't a large team of fund managers or research and bonuses to pay. Trading is also kept to a minimum as it's virtually automatic, based on the companies on the index.

It is pretty standard for the fees for actively managed funds, such as a hedge fund to be an enormous 2% of your total investment annually, plus 20% of any profits made during the year. The returns from an actively managed portfolio have to beat the index by the huge fees, just to reach a break-even point, whereas average fees for index funds range from 0.05% to 0.3%.

Fees

To illustrate the importance of fees, assuming you invested £10,000 in an account earning average returns of 6% per year. Over 25 years, your investment would grow to £43,000 if your fund manager was levying no fees.

However, if your fees were 2% annually, your investment would only grow to £26,000, meaning you would pay £17,000 in fees to the fund manager.

Fees are important - you should aim to keep them as low as possible!

Why You Should Become a Passive Investor

Most people will not be able to beat the market consistently over the long run or select fund managers who can do so. Majority of actively managed funds fail to beat their benchmark consistently. It is mostly as a result of higher trading costs and bonuses for the fund managers to pay. These increased costs combined poor performance makes passively managed index funds the clear choice for most investors.

It may be possible for you to be lucky and pick the right investments to beat the market in one year, two years or three years. It's like rolling a dice. There's a one in six chance that you'll roll a 6. The more times you roll the dice, the less your chances of consistently rolling a 6 at each throw of the dice. But to consistently beat the market over the long term i.e. rolling sixes at each throw of the dice indefinitely is almost impossible.

Let one of the UK's most successful fund managers Neil Woodford prove this point. He was able to successfully beat the market for around 15 years but has now been ousted from funds that bear his name.

As buying or selling of shares is trading with other market participants, investing can be thought of as a zero-sum game. On each trade, there will be a winner and a loser. For each person who beats the market, there will have to be someone else who underperforms. Roughly 50% of people will beat the market in any given year. When you take transaction costs into account, less than 50% of people will beat the market in any given year.

A passive investor recognises that their chances of consistently beating the market, in the long run, is slim and so will not take any chances. They will settle for the market return, which is pretty good and is higher than the return received by most market participants.

Settling for the market returns is a dull investing strategy. It's not at all exciting, which is why it doesn't receive much media attention. Reporting that the share price of Company A has increased by 125% over the last month, or hearing about the FTSE 100 reaching new all-time highs is a lot more exciting.

Investing shouldn't be exciting anyway. If you want excitement, you're better off going skiing or heading to your nearest theme park.

Summary

You're not going to outperform the market over the long run consistently. You're also not going to be able to pick out active managers who can do so consistently over the long term. As a result, you should stick to passive investing.

Not doing so is essentially destroying your wealth through the fees you'll be paying. Opportunity cost to investing is also a real cost.

You can save yourself from the stresses and anxiety of actively monitoring your portfolio every minute. Index investing is truly a buy and hold strategy, and you'll never have to worry about investing again. You sleep better at night, never having to worry about what's happening to your investments. You don't need to keep on top of financial news.

Simply pick an index you want to track and invest in it — more on how to decide on an index fund to invest in here.

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