You Need to Know About These Passive Investing Risks
True or False: Investing in passively managed funds *always* costs less and is lower risk than investing in actively managed funds or portfolios. The correct answer is false – passive investing can be not always lower cost and lower risk, and in fact comes with its own set of risks.
You need to know about these passive investing risks before you choose to invest in index mutual funds or passively managed exchange-traded funds (ETFs) over actively managed funds or personalized investment portfolios. We highlight some of the most important passive investing risks you should know.
What is Passive Investing?
Passively managed funds attempt to track the returns of a specific investment market index (benchmark) such as the S&P/TSX or S&P 500. This is achieved by holding the securities of the benchmark index in the same weightings as the benchmark index.
No company research or active security weighting decisions are involved in passively managed funds. Index fund managers make transactions only to ensure that the security weightings mirror weightings within the benchmark index.
It should be noted that passive fund managers must trade the fund’s securities frequently in order to invest cash received from new investors, to raise cash to pay to investors who are redeeming their units and to maintain security weightings in line with the benchmark index, which will periodically be adjusted to add or remove securities or change weightings. Therefore “passive investing” does not necessarily indicate a “buy and hold” mentality, but rather speaks to the lack of active scrutiny of each stock purchased or sold.
Some of the Most Important Passive Investing Risks to Know
Live and Die by the Benchmark Index (Lack of Flexibility)
Passively managed funds follow their benchmark index in both bull and bear markets. Passive investments will rise with the market, and also decline with the market. And if the market crashes…there is no downside protection. Index fund managers are typically prohibited from using defensive measure such as reducing positions or increasing cash to counter the downturn, even if the manager foresees a sector or market downturn. Passive investors are therefore left passively sitting by while their investments drop with the market.
Not Every Stock in an Index is Worth Buying and Not Every Stock Worth Buying is in an Index
Holdings are limited in a passively managed fund. No stocks can be held which are not in the benchmark index. But not every stock in an index is worth buying and not every stock worth buying is in an index. For example, passive investors could not have held Apple or Tesla prior to their inclusion in a market index.
Potential for Less Risk but Less Return
Passive investing will pretty much never be able to beat the market as their core holdings are locked into the holdings of the benchmark index. On the other hand, active investing can bring bigger rewards, and while those rewards may come with greater risk, there are some successful active investment strategies where the return-to-risk ratio may even be equal to or greater than that of passive investing as the excess returns compensate for the excess risk.
Passive Investing Risks Are Rising
The popularity of passive investing is creating its own risks. With an ever-increasing number of passive mutual funds and ETFs chasing the same index stocks, index replication is becoming less time and price efficient due to the increasing purchase competition. In 2021, $1.2 trillion poured into passive U.S. equity funds according to fund tracker Morningstar.
Compounding this is “crowding”, where increased demand for stocks by index funds may drive up the price based on demand only and not for fundamental valuation reasons, decreasing market efficiency and increasing overall risk. Passive managers will not be able to capitalize on these price increases by selling, and conversely may be obliged to buy the stocks at inflated prices, because they have to match an index weighting rather than buy and sell based on price.
In contrast, active managers can sell or trim these stocks at inflated valuations and may therefore gain at the expense of passive managers.
Your Actively Managed Dividend-Paying Portfolio with Bloom Investment Counsel, Inc.
By creating a personalized, actively managed dividend-paying portfolio that generates both capital gains and dividend income—an overall total return approach to investing – Bloom can help you protect, preserve and grow your wealth.
Since 1985, Bloom Investment Counsel, Inc. has been dedicated to providing actively managed, personalized investment management services for wealthy individuals, family offices, foundations, corporations, institutions, and trusts.
We are a Toronto-based independent, privately-owned boutique investment management firm with over 37 years of experience managing in excess of $2.5B in assets over the years.
For more than 25 years, we have specialized in one thing and strive to be the best at it—investing in income-generating investments, specifically dividend-paying stocks.
We believe that generating independent cash flow from dividend-paying stocks is central to the success of our clients’ portfolios because it provides income for the present day, if desired, while continuing to preserve and build wealth for the future.
Learn about our actively managed, customized Canadian and U.S. dividend-paying portfolios by visiting our website at www.bloominvestmentcounsel.com or speak directly with us by calling +1-416-861-9941 or emailing us at firstname.lastname@example.org
Connect with Bloom Investment Counsel, Inc. on LinkedIn to stay up to date on resources on protecting, preserving and building wealth.
This content is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this content should consult with his or her financial partner or advisor.