By definition, fund managers are active investors who are paid to pick winners and losers. This contrasts with how the vast majority of amateur, non-professional investors make investment decisions. For them, there isn’t enough time to fully research each investment opportunity and develop models from which they can build and adjust an investment model.
As a fund manager, passive investors are effectively your customers. If you work at a mutual fund, for example, you are given a certain amount of capital from your customers who are looking to you to make the decisions of who to invest in for them. It’s important to understand exactly how passive investing has built and developed certain parts of the investment industry as well as the fund products that are available for purchase on the open market by professional and amateur investors alike.
Passive Investing
Considered to be the most basic form of investing, passive investing requires little effort in an attempt to maximize returns on the time it takes to make an investment. Passive investing often means investing in an index fund or mutual fund and waiting for the fund manager to make the investments appreciate.
There are two types of philosophies behind passive investors. One type believes that markets are efficient and therefore the price of a stock reflects its true value. This is the “efficient market hypothesis” (EMH) and believers in this idea will usually invest in index funds and wait for them to appreciate. A classic example is the S&P 500 SPDR (SPY), which is often used by passive investors to buy into the S&P 500 broadly without choosing individual winners. Since there are no undervalued or overvalued stocks and all stock prices on an exchange reflect all relevant information, one instead wants to bet on broad market growth instead of the likelihood that one sector or stock will outperform. “Active management” or security selection is deemed unnecessary and a poor way to allocate capital since it is impossible to consistently beat the market.
On the other hand, other passive investors will decide that it is in fact possible to beat the market but they cannot do this themselves. These investors will often look for fund managers to make selections for them and are willing to pay a management fee to these investors in return for their time and expertise. These investors will often buy ETFs and mutual funds that they consider to be better managed than the market. Alternatively, these investors might think some sectors will outperform and will want to invest in those sectors without choosing particular winners. These passive investors do not necessarily believe in an efficient market, but do believe that others can make investment decisions more accurately due to their better information and expertise.
The Downside of Passive Investing
There are three major downsides to passive investing, the first being lack of control. Because you are investing in an index fund, you cannot select the underlying securities, meaning you are exposed to a variety of companies based more on their past profile than future potential. As a result, your portfolio’s performance is based on factors outside of your control and can appreciate more slowly than a portfolio more weighted to market winners. For EMH believers, this is no big deal—they don’t think it’s possible to pick winners anyhow. For those who don’t believe in the EMH, it requires a leap of faith that fund managers can and will continue to pick the right stocks.
The second major downside is the inability to outperform the market or index. Index funds tend to provide the same returns as do the indices from which they are derived. In fact, they are designed to work this way, and a fund that doesn’t is a bad fund worth avoiding. This means that something like SPY will rise when the S&P 500 rises, but only by that much. In a bull market some stocks will rise even higher, but your holdings will now. However, it also means that you will not experience outsized losses in a bear market, a consoling notion that helps passive investors sleep at night.
The third major downside to passive investing is that it does not reflect your skill as an investor nor does it showcase your investment prowess or ability to select winning securities or avoid bad investments. If you are using the Zolio platform, you are likely trying to enhance your skill set and test your trading strategy. If this is true, passive investing is likely not the investing style you should employ. However, if you want to invest in a particular sector as just one part of your overarching strategy, investing in a passive index fund might be for you. Several professional fund managers routinely buy index funds as part of their overall investment mix.