The days are gone when stock investing was active, full-time work. Now, a whole spectrum of investment options is available, from active to passive. According to the Investment Company Institute, passive funds held a larger share of the US stock market’s capitalization at the end of 2021—16%—compared to active funds’ 14% share. Since then, there has been a cumulative net movement of more than $2 trillion from actively managed stock funds to passive ones, especially into ETFs. This proves that with the desire for multiple income streams, passive investment strategies have become popular in recent years, allowing investors to reap from stock trading without actively managing individual stocks.
What is a passive investment?
Passive investing is a hands-off, long-term stock-holding strategy that minimizes direct market involvement by investors. It’s rooted in the “buy and hold” philosophy, enabling stock gains to accumulate organically over time in tandem with market performance. In contrast to active strategies that aim to outperform the market, passive investing replicates benchmark indices like the S&P 500, which is an index that shows the performance of the 500 largest stocks on the NYSE and Nasdaq. Opting for passive investment strategies often proves to be a more lucrative approach in the stock market. One report found that 80% of active fund managers are falling behind major indexes, primarily due to factors such as transaction costs, taxes, and the difficulty of consistently predicting long-term market trends. It’s no surprise that passive investing is preferred by many, offering cost-efficiency, simplicity, and tax benefits compared to actively managed portfolios. Some passive investors might occasionally sense opportunity in the market and temporarily enter some short-term trades. There are several reasons and ways that an investor might do this. For example, given the right circumstances, a passive investor might speculate on S&P 500 futures. Futures contracts are a derivative of the S&P 500 and offer different utility to the underlying asset. Passive investors might choose to use these tools for hedging against potential downside moves without selling any long-term positions, using leverage, or accessing markets and assets that would otherwise be difficult or expensive to buy.Examples of passive equity investment strategies
Investing in stocks through passive equity strategies is an inexpensive and stress-free way to get reap from the market. Here are several strategies you can use:Index Funds
Indexing is the most basic form of passive investing. Index funds are a simple and cost-effective way to invest in the stock market. Investing in an index fund, you’ll obtain exposure to a diverse range of companies within the index without having to pick individual stocks yourself. You can invest in an index fund by purchasing shares directly from the fund company or through a brokerage account. Before investing, review the fund’s prospectus to understand its investment strategy, fees, and risks. Index funds can help you reduce individual stock risk by allowing you to diversify your holdings across the different index components. The problem with index funds is that they can only help you reap from the market; they cannot outperform it, as they are simply a microcosm of the index’s performance. Also, your portfolio predetermined by the composition of stocks featured in the index; you do not get to choose.Exchange-traded funds (ETFs)
ETFs are investment funds that trade on exchanges, similar to individual stocks. They can track a specific index, sector, commodity, or other asset classes. While some ETFs offer specific niche stocks; they often serve as a way to lower your risk and diversify your portfolio. Additionally, ETFs are amenable to both active and passive investment strategies. However, passive investors find ETFs appealing because they feature across many different market indices and sectors like real estate and commodity trading, and, compared to mutual funds, they are more tax-efficient. The United States ETFs’ assets market is as big as $5,667.26B with an average expense ratio of 0.51%—impressive figures by any standard. However, one potential downside of ETFs is the bid-ask spread; which refers to the difference between the price at which you can buy and sell ETF shares. This spread can sometimes make it difficult to buy or sell shares at the exact price you want. Notably, some brokers may charge commission fees for trading ETFs; which can add to the overall cost of investing in these funds. Still, many investors find ETFs to be a cost-effective; and efficient way to gain exposure to a wide range of markets and sectors.Smart-Beta Funds
Smart-beta funds are a hybrid of passive and active investing, blending the advantages of both. While they may derived from traditional market-cap-weighted indexes, unlike most passive funds; smart-beta funds adjust or modify these weightings to try and outperform the market. They do this by using non-standard weighting factors like volatility, value, dividend yield, and momentum. Because these weighting schemes are not standardized, they give rise to two types of smart-beta funds: single- and multi-factor funds. For example, a low-volatility fund would give more weight to stocks with low volatility and less weight to stocks with high volatility. On the other hand, multi-factor smart-beta funds use two or more non-standard factors to determine the weight of each stock in the portfolio. For example, a multi-factor fund could use both value and momentum factors to determine the weight of each stock.4. Robo-Advisors
Another route to passive investment is the use of AI-powered robo-advisors. These are digital software that facilitates automated, algorithm-based investment with little to no human supervision. A typical robo-advisor learns by collecting information from you about your financial situation, risk tolerance, and investment objectives. It then uses the data to offer advice and automatically invest for you. Many robo-advisors are decently priced to favor smaller investors and offer valuable advice for novices who want to access professional portfolio management easily. Most of them are inexpensive, secure, and user-friendly. The criticism leveled at robo-advisors is that though they do much for traditional investing; they can prove inadequate for more complex stocks and financial situations. They also lack human subjectiveness, making them rather cold and calculating.How do you know which strategy works for you?
If you’re considering passive investment in equities, you should be versed in your objectives; the makeup of the benchmark index you use, and the methods available to you. The right passive equity investment strategy depends on your financial goals, risk tolerance, and time horizon. To help you, here are some boxes to check when selecting a passive investment style:- Decide if you want to invest for regular income, capital appreciation, or both.
- Determine your level of risk tolerance in the face of volatile markets, and make sure you choose a strategy that fits your risk profile. Some options allow you to allocate to more conservative investments like bonds, shielding your capital from market dips.
- Think carefully about your time frame, as longer time horizons may favor certain types of funds. For example, target-date funds are a type of ETF that require you to set a specific date at the onset, and they become more conservative as the date approaches.
- Consider how each strategy affects your overall portfolio. There are multi-asset class funds that provide diversification across a wide range of securities.
- Examine the costs and benefits of each strategy, including its tax ramifications, since little expenses here and there can eventually significantly influence your returns.