Passive investing involves buying and holding a portfolio of securities that automatically track the broader market. Passive investing tends to have low-cost trading structures, be easy to implement and far less time consuming.
Instruments that help you implement a passive investment strategy include Exchange Traded Funds (ETFs), Exchange Traded Commodities (ETCs) or Index Trackers that follow an index and gain you exposure to a particular benchmark without having to directly buy single stocks.
Most ETFs are replicated and mirror an index, market or industrial sector in physical form where the underlying assets are held by the product provider, while some others are synthetically replicated.
A key characteristic of a passive investment strategy is participation in a specific market without the risks associated with stock-picking. Passive investing could be considered a ‘broad brush’ approach to market exposure, free from the risks of a share sell-off affecting a specific stock rather than the broader sector or market.
For example: If you had bought shares in BP before the Deepwater Horizon oil spill in the Gulf of Mexico on 20 April 2010 you would likely have been nursing heavy losses on your investment for months afterwards. However, if you had purchased an ETF to track the FTSE 100 index - in which BP is a major constituent – the losses would have been minor, as the other large-cap stocks were uncorrelated with the BP event and their share prices compensated for some of the losses BP suffered.
The drawback of passive investing is that these instruments are providing beta exposure only – access to general market risk, whether net positive or negative – rather than the alpha exposure of active investments (the risk-adjusted performance above or below the general market risk of an index).
In other words, by definition you will not beat the index or generate excess returns (alpha) by passively investing via ETF or index tracker products .
Actively trading passive instruments
Intraday trading of ETFs enables investors to buy and sell all of the shares that comprise up an entire market such as the FTSE 100, S&P 500, Dow Jones Industrial Average (DJIA), S&P 500, CAC-40 or the DAX30 via a single trade.
While many investors can actively trade ETFs intraday, which is a popular strategy pursued by active investors, others may employ a buy-and-hold strategy over a medium to long-term timeframe to gain ongoing exposure to their particular benchmark index.
ETFs provide the flexibility to get into and out of a market position at any time throughout the trading day, which contrasts with mutual funds that trade only once per day. Index Trackers, by contrast, have their net value asset (NAV) calculated at the end of each day. By actively trading passive instruments, active traders can take advantage of short-term movements.
For example: If the DJIA appreciated sharply after positive U.S. non-farm payroll numbers are announced, active traders can immediately close out their positions to lock in profits.
Diversity of investments
While most private investors typically trade ETFs in the leading blue-chip stock market indices, there are thousands of exchange-traded products offering traders access to a host of countries, regions, industrial sectors (e.g. US biotech or forestry), sub-sectors as well as bond ETFs, commodity ETFs or ETCs, and currency ETFs.
In terms of strategy, this plethora of choice means traders are able to employ passive instruments across their multi-asset portfolio, taking positions in anything from broad market indices like the FTSE 100 or S&P500 or niche investments to best reflect their investment objective, investment style and risk appetite.
ETFs are similar to index mutual funds offering lower cost as most are not actively managed, lower turnover and broader diversification. As publicly traded securities, their shares can be bought on margin and sold short, so allowing the use of hedging strategies and traded using stop orders and limit orders, which enables investors to specify the price points at which they are prepared to trade.