What is Passive Investing?

Passive Investing, also known as passive management or indexing, revolves around the core idea of replicating the performance of a selected market index benchmark. This is typically achieved by buying units or shares in one or more index-tracking funds. The decision on which specific index benchmark to track is an important, strategic choice. Whether an investor chooses to track the S&P 500, the FTSE 100, or another index could be extremely significant on financial outcomes. Once the investor selects their benchmark index, the strategy is to buy and hold their tracking investments, with the goal of closely matching the returns of that index benchmark over the long term by replicating it as much as possible. In some cases, attempting to achieve some relative outperformance with high degree of correlation to the benchmark using similar index funds is still considered passive investing. However, others do not consider this passive investing as it involves deliberately introducing tracking error.

By contrast:

Active Investing, also known as active management is when the investor actively makes decisions to try to beat their benchmark. This includes; selecting individual securities, buying and holding index funds that significantly deviate from the benchmark, making tactical adjustments, and/or employing other ongoing decision-making strategies with the aim of outperforming a benchmark. The choice of benchmark is less significant with active investing since it is not meant to be tracked but rather intended to be beaten. For this reason, a lot of active managers often try to deliberately choose lower performing benchmarks that are easier to beat.

Index benchmark selection in passive investing is a crucial decision for passive investors, and it goes beyond just aligning with goals and risk tolerance with any suitable index. A thoughtful understanding of the underlying securities within the indices is essential for choosing a benchmark index to track that will have strong financial performance.

Here's why:

Quality of Companies: Considering the quality of companies within the index is vital. High-quality companies tend to have strong financials, stable earnings, and good governance among other attributes. Passive investors may favour indices that include companies that they feel have good prospects of stability and growth.

Valuation: Assessing the valuation of the companies within the index is important for understanding their current market prices relative to fundamental metrics. Passive investors may consider valuation metrics such as P/E ratios, dividend yields, and overall earnings growth to gauge whether the index constituents are attractively price. This will help guide the passive investor in deciding whether the index ought to be tracked.

Exposure to Specific Markets or Sectors: Different indices represent various segments of the market, and their performance can be influenced by economic, industry, or sector-specific factors. Passive investors need to be aware of the composition of the chosen index to understand the level of exposure they are getting to specific markets or sectors.

Risk and Return Characteristics: Indices can have different risk-return profiles. Some indices may be more volatile due to concentration in certain sectors or asset classes, while others may offer broader diversification. Passive investors should carefully consider how the risk and return characteristics of the chosen index align with their investment objectives.

Market Capitalization: Indices may be weighted by market capitalization, meaning larger companies have a greater impact on the index’s performance. Understanding the implications of market cap weighting is essential for investors, as it can influence the portfolio’s exposure to mega-cap stocks versus smaller companies.

Sector and Industry Exposure: Passive investors should be aware of the sector and industry exposure of the chosen index. Certain indices may have heavy concentrations in specific sectors (e.g., technology, healthcare, finance), and investors should evaluate whether this aligns with their sector preferences or diversification goals.

Geographic Exposure: Indices can be global, regional, or country-specific. Passive investors should be mindful of the geographic exposure of the index, considering factors such as currency risk, geopolitical considerations, and regional economic conditions.

Methodology of Construction: Understanding how an index is constructed is crucial for passive investors. Some indices use market capitalisation weighting, while others may use alternative methodologies like equal weighting or factor-based weighting. The construction methodology can influence the characteristics of the index and, consequently, the investor’s exposure and future performance.

In summary, while passive investing involves tracking an index, not all indices are the same, and their characteristics can significantly impact investment outcomes. Passive investors benefit from understanding the intricacies of indices, ensuring that the benchmark selected not only aligns with their overall goals and risk tolerance but also leads to good performance. Therefore, having a clear understanding of the underlying securities, quality, and valuation among other factors that impact the index’s performance is crucial for the passive investor.