What is passive investing?

Key takeaways

  • Passive investments track or follow an index representing a market or markets.
  • When an investment does not replicate the index exactly, the difference between the return of the index and that of the investment is known as the tracking error.
  • An index-tracking investment delivers the return of the market less its fees and any tracking error.
  • Index-tracking investments generally charge lower fees than actively managed funds because the manager does not need to do extensive research.
  • Tracking an index offers a low-cost access to a diversified basket of shares or other securities and a way to earn close to the return of the market (known as beta).

 

Passive investing is an investment strategy that seeks out the return you could get being invested in a financial market at a low cost.  

These investments are set up to generate returns that are in line with that of an index made up of, for example, all the shares on a stock market, or the shares on top stock markets globally.

The investment strategy is said to be passive because the fund manager does not make active decisions about individual shares or any other security in which to invest – instead the manager buys and holds the shares or securities in the same proportion in which they are represented in the index.

The manager is therefore said to passively track or follow the index.

These index-tracking investments typically have lower fees than actively managed funds as the fund manager does not need to research which shares or other securities to buy. In addition, the manager only buys and sell those securities when a share or security moves in or out of the index, so trading costs are typically lower than those on an actively-managed fund.

You can therefore get a broadly diversified investment from which you expect to earn the return that the market delivers for the cost of only a small fee.

 

Alpha and beta

You may see or hear references to alpha and beta when passive and active investments are written or spoken about.

Beta is used to describe the return the market can deliver and alpha to describe the return above the market that an active manager can potentially earn.

 

How can you access an index-tracking investment?

Exchange traded funds and index-tracking unit trusts offer easy ways to invest in an index-tracker.

There are some managers that specialise only in index-tracking investments, while other larger financial services groups have specialist divisions or companies within their larger group offering index-tracking investments.

You can also invest in index-tracking investments through investment platforms. There are even some platforms that only offer ETFs.

Most but not all exchange traded funds are also unit trust funds (collective investment schemes).

The difference between ETFs and index-tracking unit trust funds is that ETFs are listed on a stock exchange. Read more: What are the differences between an ETF and a unit trust?

 

Tracking errors

The accuracy with which an investment or fund tracks an index is measured by its tracking error.

An index-tracking investment will always be slightly out relative to the index it tracks because of the investment fees and securities transfer tax. Cash held to pay out investors may also affect a fund's tracking error. 

Some index tracking investments deliberately do not track the index exactly – they will, for example, not buy the smaller shares in the index in order to reduce costs. These smaller shares make such a minor difference to the performance relative to the index, that the cost saving negates the effect of not holding them.

 

DID YOU KNOW?

The first market indices were launched by the Dow Jones & Company in the late 1800s to track the performance of actively managed funds.

The first mutual fund that tracked an index was opened to investors in 1976 by Vanguard, now one of the world’s largest passive investment managers.

To track an index, the manager needs to buy the intellectual property to track the index from the index provider. The index provider informs the manager on an ongoing basis about the changes in the index so that the manager can make the necessary changes to the fund or portfolio tracking the index.