The Beginner's Guide to Picking Passive

Diversification may be the only free lunch in finance, but passive strategies are not the only way of achieving it, and they come with their own unique downsides

Catherine Elliott 12 January, 2022 | 10:24AM
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ETFs under a magnifying glass

The passive universe continues to gain momentum as more investors move away from actively managed funds in favour of passively managed alternatives.

In fact, last year, passive mutual funds and ETFs made up 20% of the assets in Europe’s €9.4tn fund industry, with an impressive 9.5% growth over the previous 12 months.  By comparison, active grew by just 2.1%. Europe also boasts the largest and most comprehensive market for passively managed sustainable funds, accounting for more than three fourths of global assets.

What’s driving this increase, what are the supposed advantages of passive strategies, and why are they winning over investors?

First, let’s take a look at what defines a passive investment.

A passively managed fund is a fund whose investment securities are not chosen by a portfolio manager, but are automatically selected to match an index or part of the market. By contrast, active strategies do not track an index. Instead, active fund managers make specific security selection decisions based on their own ongoing research, analysis and expertise.

The two main investment vehicles used to invest passively are index mutual funds and exchange-traded funds (ETFs). With an index mutual fund, the manager chooses investments to mimic the benchmark. Some index funds buy all the stocks in their benchmark index, while others use optimised sampling to closely match the index’s return without owning every security.

ETFs, meanwhile, consist of “baskets” of securities. Shares in the basket are then sold on an exchange, and are traded as normal throughout the working day.

Why are passive investments appealing?

Passive investments carry key benefits. Most notably, they are generally cheaper as their fees are lower. This is because the process of tracking an index can be highly automated, and costs can be minimised through scale.

This has been a major factor in the rise of passive investing, as the higher fees of actively managed funds do not always equate to better returns. Harnessing the collective wisdom of the market at a low cost, passive funds in most markets have proved difficult to beat over longer time horizons.

Passive investments also promise greater transparency. In most cases, an investor can access detailed index methodologies, which clearly describe the investment process and compare directly against fund holdings, which are published at least daily. Most passive funds employ easy-to-grasp strategies, and therefore require less monitoring and a lower due diligence burden.

Described as the “the only free lunch in finance” by Nobel Prize winner Henry Markowitz, the benefits of diversification are well-known. Passives and broad market trackers tend to be well diversified too. For example, a fund tracking the MSCI World index can provide exposure to over 1500 separate stocks. This helps to maintain a healthy portfolio balance by distributing financial risks across multiple industries and instruments.

Of course, passive strategies are not without their limitations. Because a passive investment promises the return of the market, funds are compelled to keep buying as the market overheats and, conversely, are forced to sell in line with a panicked market when crashes or corrections hit. Not all passive funds track simple, transparent indices either, meaning some of the more complex funds including ESG and thematic funds can be somewhat of a black box.

Finding The Right Passive Plays

Long gone are the days when investors weighing index-tracking strategies only had a relatively small number of simple, well-known indexes to choose from. Today, investors are faced with a bewildering array of passive strategies. That can be overwhelming if you don’t know what you’re looking for.

Morningstar has one of the largest independent manager research teams in the world, helping professional investors sort through the myriad of passive strategies available to scrutinise individual offerings and trends.

At the core of our research lies the Morningstar proprietary ratings system which can be used to rate and analyse passive funds, as well as Morningstar Indexes which can serve as a precise benchmarking resource and be used in the construction of passive portfolios.

To learn more about passive investments and how Morningstar’s research and ratings can help, download your free copy of our Guide to Passive Investing here.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Catherine Elliott  is a content writer at Morningstar