Your Investment Guide on Passive Investing

Passive investing over time is becoming one of the most sought-after methods to make investments. This strategy, involving minimum purchasing and selling of securities while boosting the returns on investment, can serve as an alternative income source in the long run. One of the most common types of passive investment is an index fund.

To get clarity about what is passive investing and some insights into the features, advantages, and strategies of passive investing, continue reading below.

What is Passive Investing?

Passive investing is a long-term investment technique where the investor purchases and holds the portfolio to maximise the returns in the long run. Here, the investor buys an assortment of financial instruments to keep up with the market rather than attempting to outsmart it. Passive investment is generally more affordable, less complicated, and risky than active investments.

Unlike active investors, passive investors don’t go after short-term profits that are a result of price fluctuations or market conditions. The investment portfolio in passive investing is diverse and largely based on broad, market-centric indices.

The most common type of passive investing strategy involves index funds, with some of the most common index funds being in sectors like equities, real estate, commodities, equities, and currencies.

Features of Passive Investment

Here are the major characteristics of passive investment –

• Affordable Investment Option – Since there is a lack of frequent buying and selling of instruments, minimal transaction costs are involved. Even though management fees are levied on the funds, several exchange-traded funds charge a fee of less than 1%.
• Based on Assumption – The primary principle behind passive investment strategies is the assumption that the stock market will go up in the long run. By imitating the market condition, the portfolio appreciates too.
• Diversified Portfolio – Passive investing strategy is an economical way of diversifying the portfolio. This is so because index funds outspread the risk by maintaining an assortment of financial assets from their target standard. Investors can also diversify their portfolios within sectors and various asset classes.
• Buy and Hold Strategy – This investment approach employs a buy-and-hold strategy to match the market index performance and does not need frequent trading. It is ideal for investors who want long-run capital gains.
• Transparent and Easy to Comprehend – Active funds are managed by professional managers, which means that they are less transparent as the manager may modify the portfolio frequently without informing you. However, in the case of passive investment, you as the investor, know the exact make-up of the assets. This makes it easy to understand and track whenever required.

Benefits of Passive Investing

The following are the benefits of passive investing –

• Lower Maintenance – Generally, it is difficult to keep track of securities’ performance. However, as a passive investor, you won’t need to keep a frequent check on your investment portfolio as your fund would be locked in securities like a market index for the long run. Thus, you don’t have to bother about predicting the market winners.
• Consistent Returns – As per a barometer report from Morningstar, passive funds tend to outperform active funds in the long run. It is reported that only 25% of active funds have outperformed passive ones in the past decade.
• Removal of Unsystematic Risk – Unsystematic risk refers to the risk of choosing the wrong investment assets or investing funds at the wrong time. When one invests in passive funds, such risks are mitigated as this investment strategy does not offer flexibility to frequently trade in securities.
• Lower Fees – As there is minimum trading involved in passive investment, the expense ratio is lower than in active investment. The investment team does not have any role in selecting the stocks and predicting the amount of time for which they should invest in security. Thus, there are minimum fund management fees and transaction costs.
• Portfolio Diversification – The indices are created to represent the overall market and include funds from varied sectors. This helps in diversifying the portfolio across all the major market segments with just one investment product (index funds).

Financial Instruments for Passive Investing

Several investment instruments can help you become a passive investor, with the two most common instruments being index funds and Exchange-Traded Funds (ETFs). They both are forms of mutual funds that offer easy returns on investment. Since the two have stakes in different industries, passive investing becomes easy. They enable portfolio diversification; if one asset incurs losses, it does not affect the entire portfolio. 

Given below is a detailed description of index funds and ETFs –

Index Funds

Index Funds imitate the performance of the equities and provide high returns on investment in the long run. You can passively invest in these funds and track the appreciation and depreciation of the selected companies or assets in the index. They generally perform better than actively-managed funds and are suitable for wealth creation over the long term, making them the most sought-after retirement plan.

You can purchase or sell the index funds at fixed prices once the market closes and their net asset value is declared. These funds require regular rebalancing because the index providers continuously include and remove companies from the lists. Rebalancing ensures that your investments are in tune with your financial goals.

Some of the best index funds in the UAE are NASDAQ Dubai, Saxo Capital Markets, Vanguard 500, and TD Direct International.

ETFs

Exchange Traded Fund, an assortment of stocks and bonds, is a type of mutual fund that enables you to invest in diverse securities at once. ETFs are suitable for you if you plan to individually manage the passive portfolio. You can trade ETFs during market hours. 

Unlike index funds, you can trade ETFs. Similarly, they are more affordable than index funds. You can purchase a single fund at the same price as the stock but have more diversification than the stock would provide. To diversify by sector, you can purchase ETFs in stocks and bonds as well as international ETFs.

Things to Consider Before Opting for Passive Investment

While passive investment is fairly easy and tends to bring high returns, you should keep the following things in mind when investing in passive instruments to gain optimal returns without major risks –

• Invest according to your risk tolerance – Before selecting a fund to invest in, you should be mindful to invest according to your risk appetite. This is so because a majority of investors run after returns without studying the volatility of the investment, which, as one may guess, results in a bad investment.
• Tracking Difference – It is a difference between the returns on the index and the return of the fund. It is not possible for an index fund to perfectly track or imitate the benchmark. Costs like that of trading and expense ratio create a small tracking error each year. You should avoid investing in funds with high tracking errors.
• Sector Funds – Sector funds are a combination of stocks and mutual funds and are suitable investment options for investors who are looking for short or medium-term growth in a sector without purchasing a specific stock.
• Asset Allocation – One can easily build a portfolio using index funds and ETFs, which are a blend of debt, stock, commodity, and international funds. For those looking forward to building an investment portfolio in a long run, passive investment instruments certainly make for a great option.

Key Takeaways

• Passive investing is a long-term investment method where the investor buys and holds the portfolio to earn high returns in the long run. Here, the investor buys a blend of financial instruments to keep up with the market rather than aiming to outmanoeuvre it. Passive investment is more affordable and less complicated and risky than active investments.
• Some of the main features of passive investing are affordability, strategies based on assumption that the market will be on the rise over time, transparency, ease of understanding, and portfolio diversification.
• Passive investing is becoming a sought-after investment method as it requires low maintenance, provides consistent returns, charges minimal fees, removes unsystematic risk, and enables portfolio diversification.
• Several investment instruments can help you become a passive investor. The two most common instruments are index funds and ETFs (both being forms of mutual funds) that offer easy returns on investment. Since the two have stakes in different industries, passive investing becomes easy. They also enable portfolio diversification in that the loss incurred by one asset does not affect the entire portfolio.
• Index Funds mimic the performance of the stocks and provide high returns on investment in the long run. You can passively invest in these funds and track the rise and fall of the selected companies or assets in the index. They perform better than actively-managed funds and are ideal for creating wealth in the long run.
• Exchange Traded Fund is a blend of market instruments like stocks and bonds. It is a type of mutual fund that enables you to diversify your portfolio. ETFs are suitable for you if you are planning to individually manage a passive investment portfolio. Unlike index funds, you can trade ETFs during market hours.
• One can also passively invest using the Robo-advisory platform. Robo-advisors are automatic investment services that employ computer algorithms and advanced software to develop and manage the investment portfolio. This option is suitable for people who want to access the financial market easily.
• You should consider certain factors when considering passive investing like tracking error, sector funds, risk appetite, and asset allocation.