Introduction

Passive investment management is the opposite of active management. Passive managers generally believe it is difficult to out-think the market, so they try to match the performance of the market (or their chosen sector) as a whole. They tend to do this by closely following or tracking an investment index, such as the FTSE 100 Index of the UK’s biggest 100 companies. That’s why passive investments are often called index funds or tracker funds. These have a simple, precise objective: to match a specific index, rather than try to beat it. Passive managers do this by buying and holding all or a representative sample of the securities in the index.

Things to consider

– Diversification: Maintaining a well-diversified portfolio is an essential part of a successful investment plan, and indexing can be an ideal way to achieve diversification. Index funds provide a broad spread of risk because they hold all (or a representative sample) of the securities in their target benchmarks.

– Total market risk: Index funds track the entire market: so when the overall stock market (or bond prices) fall, so do index funds.

– Low costs: As index funds track a target benchmark or index rather than looking for winners (and so can avoid constantly buying and selling securities), they generally have lower fees and operating expenses than actively managed funds.

– Lack of flexibility: Index fund managers are usually prohibited from using defensive measures such as moving out of shares, even if the manager thinks share prices are going to decline.

– Simplicity: An index fund offers an easy way to invest in a chosen market as it simply seeks to track an index. There is no need to select and monitor individual managers, or chose between investment themes.

– Performance constraints: Index funds are designed to provide returns that closely track their benchmark index, rather than seek outperformance. They rarely beat the return on the index, and are likely to return slightly less as a result of fund operating costs.

Summary

Importantly Passive Investing will not reduce risk, say you held a passively managed S&P 500 index fund from January 2007 until January 2009. That was a period of decline for the stock markets. Faithfully mirroring the index, your fund, and you, would have lost 39% of its value. With passive products, there’s no manager there to adjust the portfolio to protect against downside risk. You’re riding the wave of the market and that at times can be a scary ride.

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