Passive investing

Passive investing is the opposite of active investing. It is often taken to be synonymous with index tracking. However there are many other passive strategies, such as buy and hold strategies — especially mechanical ones.

The strongest argument in favour of passive investing is that the market is efficient, and therefore efforts to beat the market are likely to achieve little more than increase costs. It is also inevitable that at least as many active investors will under-perform the market as will out-perform. Trying to beat the market is a zero sum game.

This means that it is possible to argue for passive investing even if the market is not efficient, because most investors will under-perform the market.

Given that the average investor will perform in line with the market, index tracking offers the advantages of lower volatility, and much lower costs. Tracker fund charges are much lower than those of active fund managers.

There is strong evidence that the rebalancing required by index trackers destroys value. This suggests that it is better to follow a buy and hold strategy, even a buy and hold strategy based on market weightings.

It is sometimes argued that by allocating assets to the largest companies, exposes investors too much to the largest sectors. Although a different allocation might give a lower volatility, it will do so at the expense of returns, because the market portfolio is on the efficient frontier. A better strategy for controlling risk would be to move along the capital markets line by buying risk free assets.

The reason for this might be clearer if you consider the CAPM. Sectors that have a heavy market weighting will have a higher correlation with the performance of the market. They will therefore have a higher beta, and their future returns will be more heavily discounted. Therefore such sectors will have higher expected returns.

Copyright © 2005-2016