Passive investing

Passive investing (also called passive management) is a strategy in which an investor (or a fund manager) invests in accordance with a pre-determined strategy that doesn't entail any forecasting (e.g., any use of market timing or stock picking would not qualify as passive management)February 2015 version of the Wikipedia article on "Passive management". The idea is to minimize investing fees and to avoid the adverse consequences of failing to correctly anticipate the future. Passive management is the opposite of active management, which typically aims to beat the market.Investopedia, Passive Management, viewed March 6, 2018Vangard Research, The case for index-fund investing for Canadian investors, April 2015, viewed December 26, 2015
The most popular passive investing strategy is to mimic the performance of an externally specified index: this is known as indexing. Retail investors typically do this by buying one or more index funds or exchange-traded funds (ETFs) that track a broad market index. By tracking an index, an investment portfolio typically gets good diversification, low turnover (good for keeping down internal transaction costs), style consistency, and extremely low management fees. With low management fees, an investor in such a fund would have higher returns than a similar fund with similar investments but higher management fees and/or turnover/transaction costs.William F. Sharpe, Indexed Investing: A Prosaic Way to Beat the Average Investor, May 1, 2002, viewed January 22, 2015.
Sharpe defines passive investing in the following manner:
In this definition, passive investing means indexing. Orthodox passive investors will select index funds or ETFs that track capitalization-weighted total market indexes.Zoll, A, 2012, S&P 500 vs. Total Stock Market: Which Is Right for You? Morningstar. Viewed January 6, 2018 But other strategies can be considered passive, or relatively passive, such as fixed income ladders, or funds and ETFs that follow non-traditional indices or select securities by using predefined screens without human intervention.Zoll A (2015) 'Passive' doesn't always mean 'index', Morningstar "Ask the Expert", viewed March 7, 2018. The rest of this article uses 'passive' in the 'indexing' sense.
==Rationale for passive investing==
The concept of passive management is counterintuitive to many investorsBurton G. Malkiel, A Random Walk Down Wall Street, W. W. Norton, 1996, ISBN 0-393-03888-2: why settle for the return of the index (minus fees) when active management offers the possibility of "beating the market"? The reason to choose passive management is that few active investors actually manage to beat the market over the long term.
===Active management's results===
Canadian mutual funds with active management have a hard time beating their benchmarks over five years, as shown by the following table:
Percentage of funds outperforming the index over five years, as of June 30, 2019; June 30, 2015; and June 30, 2010
Fund category 	Comparison index 	Mid 2019S&P Dow Jones, SPIVA® Canada Scorecard Mid-Year 2019, viewed March 22, 2020. (%)	Mid 2015S&P Dow Jones, SPIVA® Canada Scorecard Mid-Year 2015, viewed December 26, 2015 (%)	Mid 2010S&P Dow Jones, SPIVA® Canada Scorecard Q2 2010, viewed December 30, 2015 (%)
Canadian equity 	S&P/TSX Composite 	12 	23 	1
U.S. equity 	S&P 500 (CAD) 	7 	3 	9
International equity	S&P EPAC LargeMidCap (CAD)	20 	4 	12
The ten year numbers are typically worse, with for example only 2% of actively managed funds beating their benchmark in the US equity category.
Actively managed fixed income mutual funds do not have a good record of beating their benchmarks in Canada either. Over ten years as December 31, 2014, one study found that 0% of short term bond funds funds beat their benchmarks, whereas 4% of medium term bond funds did. Over five years, the figures were 2% and 4%.
The rest of this section offers both a simple explanation of why passive investing works, i.e. "costs matter"John C. Bogle, Whether Markets are More Efficient or Less Efficient, Costs Matter, from the Nov-Dec 2003 issue of CFA Magazine, viewed January 5, 2015., and the more complex ones of financial economics.
===Explanations===
The following figure sums up the main reason why passive investing works: the costs are lower.In The Four Pillars of Investing, introduction to Chapter 3 ("The Market Is Smarter Than You Are"), William Berstein provides the following humorous illustration of why active management typically fails:
"Pretend (…) you live in an obscure tropical country called "Randomovia". (…) it has one serious problem: a rampant chimpanzee population. (…) The Randomovians periodically round (the chimpanzees) up, dress them in expensive suits, place them in luxurious offices, and allow them to manage the nation’s investment pools. (…) They pick stocks by hurling (darts) at the stock page. This means three things about Randomovia: 
*Over any given period of time, some of the chimpanzees will be lucky and obtain high returns. 
*The past performance of a chimp at selecting stocks has no bearing on this future performance. Last year’s or last decade’s, winner will just as likely be a loser as a winner next time. 
*The average performance of all the chimpanzees will be the same as the market’s, since chimps are the only ones who can buy and sell.
The chimps each have about a 50% chance of beating the market. There’s only one problem: The investment pools they manage charge the Randomovians 2% of assets each year in expenses. In any given year, the differences in performance are great enough that the 2% expense does not matter that much. But because of the 2% drag, instead of 50% of the chimps beating the market each year, only about 40% of them do. With the passage of time, however, the law of averages catches up with all but the luckiest chimps. After 20 years, only about one in ten beats the market by more than their 2% annual expenses. So, the odds of your picking that winning chimpanzee are … one in ten. 
Well, dear readers, I have very bad news. For the past several decades, financial economists have been studying the performance of all types of investment professionals, and their message is unambiguously clear: Welcome to Randomovia!"
Figure (modified from Vanguard's publications): investing is a sum-zero game. The dollar-weighted performance of all investors (hypothetical bell curve on the right) is equal to the performance of the market. After costs, the curve is shifted to the left: few high-cost active investors beat the index every year. Low-cost index funds and ETFs have returns close to that of the index, outperforming most active investors.
Another explanation of the comparative success of passive investing is that active managers may miss the best performing stocks in an index, and these account for a significant proportion of returns: "the entire gain in the U.S. stock-market since 1926 is attributable to only 4% of the stocks".Heaton JB, Polson N, Witte J (2017) Why Indexing Works. Applied Stochastic Models in Business and Industry v. 33, doi:10.1002/asmb.2271 Available on SSNR
===Financial economics===
The rationale behind indexing stems from several concepts of financial economics:
# In the long term, the average investor will have an average before-costs performance equal to the market average. Therefore the average investor will benefit more from reducing investment costs than from trying to beat the average.John Y. Campbell, Strategic Asset Allocation: Portfolio Choice for Long-Term Investors. Invited address to the American Economic Association and American Finance Association. Atlanta, Georgia, January 4, 2002. Retrieved May 20, 2010
# The efficient-market hypothesis postulates that equilibrium market prices fully reflect all available information, or to the extent there is some information not reflected, there is nothing that can be done to exploit that fact. It is widely interpreted as suggesting that it is impossible to systematically "beat the market" through active management, although this is not a correct interpretation of the hypothesis in its weak form. Stronger forms of the hypothesis are controversial, and there is some debatable evidence against it in its weak form too. For further information see behavioural finance.
# The principal–agent problem: an investor (the principal) who allocates money to a portfolio manager (the agent) must properly give incentives to the manager to run the portfolio in accordance with the investor's risk and return appetite, and must monitor the manager's performance.Agency Theory, Agency Theory Forum. Retrieved May 20, 2010.
# The capital asset pricing model (CAPM) and related portfolio separation theorems, which imply that, in equilibrium, all investors will hold a mixture of the market portfolio and a riskless asset. That is, under suitable conditions, a fund indexed to "the market" is the only fund investors need.
Some active managers may beat the index in particular years, or even consistently over a series of years.Passive money management strategy actively crushing stock pickers | Breakout - Yahoo Finance Yahoo Finance Nevertheless the retail investor still has the problem of discerning how much of the outperformance was due to skill rather than luck, and which managers will do well in the future.John Bogle, Bogle on Mutual Funds: New Perspectives for the Intelligent Investor, Dell, 1994, ISBN 0-440-50682-4
==Popularity of passive management==
===Mutual funds and ETFs===
Passive management in the form of index mutual funds and index ETFs is on the rise:
* In Canada, the market share of these passive strategies was 13% at the end of 2020, up from 8% in 2011, based on Morningstar data.Kerzérho R (2021) The Passive Vs. Active Fund Monitor - yearend 2020, PWL Capital White Paper, 22 p., viewed March 13, 2022. 
* In the US, passive strategies represented 40% of mutual fund and ETF assets at the end of 2020, up from 22% in 2011 
* During the 2011-2020 period, there was a net ouflow of money from active funds in the US, and a strong net inflow into passive funds
* Finally, over the same 2011-2020 period, worldwide data shows that passive funds went from 13% to 28% of assets under management
One reason for the rise of passive strategies in the assets held by individual investors might be the evolving landscape of advisor compensation in several countries. According to The Economist, "One reason for the rise of ETFs is the changing behaviour of financial advisers. Historically, many earned commissions, paid by the fund-management company whose products they sold and incorporated in the annual management charge. This system created a conflict of interest: the products that were best for advisers to sell were not necessarily the best products for clients to own."The Economist, Will invest for food -- Like books and music, the investment industry is being squeezed, May 3, 2014, viewed December 27, 2015 If advisors don't directly profit by recommending higher cost active products, they might be more prone to propose lower-cost passive products. 
In Canada, most investment advisors are still compensated based on commissions, which might contribute to the lag in passive popularity relative to the rest of the world and the US in particular. Also, in Canada, "the manufacturers of investment products and the investment advisory industry are vertically integrated within a small number of mega-financial groups", which makes "the market less competitive than it is south of the border". 
Other possible reasons why more investors have not yet embraced indexing is "the nagging feeling that there’s something better out there" (elusive market-beating strategies), and a difficult to overcome resistance to simplicity.Canadian Couch Potato, Why Simple Is Still a Hard Sell, January 25, 2016, viewed on the same date
===Pension funds===
Nicolas Firzli, director general of the World Pension Council, estimates that “14-16 percent of total worldwide (pension) assets are invested in passive mandates”.Rachael Revesz, Why Pension Funds Won't Allocate 90 Percent To Passives, Journal of Indexes - ETF.com, November 27, 2013, viewed December 27, 2015 A survey of US institutional managers reveals that 88% “expect the market share of institutional index funds to exceed 20% in the coming three to five years” PWL Capital blog, The growing momentum of index investing, December 4, 2014, viewed December 27, 2015
In Canada, only 4% of defined benefit pension assets were passively managed in 2013.Fred Vettese, Why don’t Canadian plan sponsors like passive management?, October 11, 2013, viewed December 30, 2015 According to Fred Vettese (chief actuary, Morneau Shepell), the primary reason for this is that "many plan sponsors haven’t seriously considered the question".
==Issues with passive investing==
Passive investing works very well with Canadian bonds, US equities and International equities. There are some potential issues with applying indexing to Canadian Equities, because our stock market is influenced by a relatively small number of stocks and concentrated in a few key sectors. This is discussed in Diversification: sector concentration and index concentration and solutions are examined in Diversification strategies.
==See also==
*Portfolio design and construction
*Simple index portfolios
*Investment styles
==Notes==
==References==
==Further reading==
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* 
==External links==
* Wikipedia, Passive management
* Canadian Couch Potato
* The Economist, Cheap is cheerful -- The business of managing other people’s money is being commoditised. About time, May 1, 2014: Two things have held them back... One is distribution: the people who sell funds to investors have had little incentive to sell cheap ones... The other problem is a belief that investors can do better than the index by picking a hot fund: money for old hope.
* Vanguard Research, The case for low-cost index fund investing, April 2019
* Vanguard Research, Prevailing myths and misconceptions of the active/passive decision in Canada, September 2019
* Ben Felix's YouTube channel: Reasons to Avoid Index Funds (reasons are listed, but dismissed one by one), April 2019
Category:Investment styles
Category:Investment management