The Rise of Passive Investing in Today's Market

As the number of passive plays continues to surge, it's essential to have a thorough understanding of the passive funds landscape

Joshua McAlpine 6 June, 2024 | 2:54PM
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What is Passive Investing?

Simply put, passive funds are a type of fund whose investment securities are not chosen by a portfolio manager. Instead, they are automatically selected to match an index or part of the market.

In contrast to a passive investment strategy is active investing, a notionally higher-risk higher-reward investment strategy where a professional or retail investor selects and manages individual securities or funds. With active investing, the end goal is to outperform a specific benchmark or the overall market.

What Are The Different Types of Passive Investment Funds?

When it comes to passive investment funds, there are two main types you may already be familiar with: index mutual funds and exchange-traded funds (ETFs).

Index Mutual Funds

These have been around for the last 50 years or so. As a passive investment fund, they've proved popular as they offer low-cost returns aligned with the market through mirroring benchmark investments. Their strategy focuses on replicating all stocks or using optimised sampling. Index mutual funds are considered a more transparent investment vehicle, with strict rules and fund holdings which are published daily. Importantly, index mutual funds can only be bought or sold once per day, after the market has closed.

Exchange-Traded Funds (ETFs)

These were introduced in the 1990s. ETFs are similar to index mutual funds, although they are seen as more of an upgrade, offering more trading flexibility (like stocks). ETFs can be bought and sold at various prices throughout the trading day. While passive investing as an overall strategy involves broad market indexes like the S&P 500 or FTSE 100, ETFs can provide more diverse market exposures, such as ESG strategies and thematic ETFs, which enables investors to invest in specific themes, like Artificial Intelligence or Healthcare. It's important to note that some ETFs can be actively managed.

Why Investors Are Paying Attention to Passive Investments

Historically, the popularity of passive investment funds has varied by region. In the United States, the last 20 years has seen an enormous shift in the market away from active funds to passive investment vehicles. This shift has been, in large part, due to the infamously-low success rate of active managers within the US equity field.

In Europe, passive investing remains popular, with appetite for long-term funds growing. Research from Morningstar Direct's European Asset Flows Commentary (source: Morningstar Direct Compass), shows that long-term index funds posted inflows of €13.41 billion (£11.4 billion) in April 2024, while actively managed funds experienced €1.86 billion in net outflows. Additionally, the market share of long-term index funds rose to 27.96% as of April 2024, up from 24.79% in April 2023.

ETFs as a passive investment vehicle have performed particularly well across Europe. According to research from Morningstar's European ETF Asset Flows Update Q1 2024 (source: Morningstar Direct Compass), while the European exchange-traded fund and exchange-traded commodity market received €44.5 billion of flows in the first quarter of 2024, down slightly from €47.4 billion in the last quarter of 2023, performance was still strong. Assets under management grew to €1.81 trillion, up from €1.64 trillion at the end of 2023, marking a 10% increase in the quarter and setting a record high for the market.

How do I Invest in Passive Investment Funds?

Arguably, it's never been easier to invest in passive funds. But when you're picking passive investment funds, there are a wide range of options, and many platforms now offer commission-free trading.

But as with every investment, the key to building a successful portfolio is first-class due diligence. As part of this due diligence process, you'll need to select your index, for example, the S&P 500 or Nasdaq 10. It's essential you have a thorough understanding of the index you'd like your funds to passively track, as this represents your investment proposition and philosophy. In short, make sure the index you select is aligned with your investment objective.

Cut Through The Noise With Morningstar

As the number of passive plays have skyrocketed in recent years, it's no wonder many professional investors are feeling confused. That's where Morningstar comes in. We have a suite of solutions, including our comprehensive Morningstar Direct™ platform – to help financial market participants at every step of the process.

Morningstar Research: our world-class team of analysts are constantly evaluating the passive fund landscape, enriching our extensive data with their expert insights.

Proprietary Ratings: our unique rating system makes it easy to compare different passive funds, and with our easy-to-grasp visualisations, you can help clients get to the metrics that matter.

Morningstar Indexes: our precise benchmarking platform is an essential resource when it comes to constructing successful passive portfolios.

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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Joshua McAlpine  Joshua McAlpine is content writer at Morningstar

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