Passive investing is an investment strategy where individuals or institutions aim to match, rather than outperform, the stock market by mimicking the performance of a specific index, such as the FTSE 100 or the Nasdaq. Instead of trying to select individual stocks or time the market, passive investors buy and hold a diversified portfolio that reflects the broader market or a particular sector. Passive investment is sometimes characterised as, “If you can’t beat them, join them”. And that’s a pretty fair summary

It’s the opposite of active investing; individual investors will research companies and stocks to choose where to invest their money. The aim is to pick stocks that outperform others and generate gains that beat a certain benchmark. The benchmark is what success is measured against for active managers. UK retail clients often use the FTSE 100 or FTSE All Share as a benchmark to measure how their portfolios are performing, which, if things go well, allows them to say they ‘beat the market’

Passive investors see the market as fundamentally efficient and believe there is limited potential for outsmarting it. Crucially, they also see unnecessary risk and cost in trying to do so

Passive management isn’t about picking hot stocks, market timing, or quick wins; it is a ‘big picture’ approach that looks to build wealth gradually over time. The fundamental assumption is that the market can be trusted to deliver positive returns over long periods

How does passive investing work?

Passive investing was first made available for retail investors in 1976, when Jack Bogle, founder of Vanguard, created the world’s first retail index fund. It tracked the S&P 500 – an index of the 500 largest companies in the US

Bogle’s motto nicely encapsulates passive investing: “Don’t look for the needle in the haystack. Just buy the haystack”

A passive strategy involves very little buying and selling. Instead of hand-picking the individual stocks or bonds a fund will hold, passive investors will buy all (or a representative sample) of the stocks and bonds in the index being tracked

The strategy is to mirror the performance of an entire market, index or area of a market and protect investors from human error, which is ultimately always a risk with an actively managed fund.

The FTSE 100 is a commonly tracked UK market. It is an index of the UK’s 100 largest companies based on their market capitalisation. Typically, a passive fund manager will purchase shares in all 100 companies listed in the FTSE 100 proportionate to their value in the index. This way, the fund can replicate exactly the performance of the FTSE 100 index over time

As the composition of the index changes over time, the fund manager replicates those changes, ensuring returns consistently track the index’s performance over the long term

Passive returns are dependent on the performance of the index itself. If the benchmark you are tracking falls, so will your fund. If it rises, your fund will increase as well

These funds are also known as tracker or index funds

Passive investing strategies

There are several ways to be a passive investor. Two common ways are to buy index funds or Exchange-Traded Funds (ETFs). Both are types of mutual funds—investments that use money from investors to buy a range of assets—and both are commonly used in passive strategies

Because index funds and ETFs let you invest in holdings from various industries and asset classes, passive investing can help you diversify, so even if one asset in your basket has a downturn, it shouldn’t affect your entire portfolio

Index funds

One of the most common strategies used by passive investors is to buy index funds. An index fund is a type of mutual fund that uses money from investors to buy a range of assets and then tracks the rise and fall of the assets within the index

With this strategy, investors spread their money across many stocks in an approach known as diversification. A diversified portfolio aims to lower exposure to the potential losses of any one industry or asset class. It is an insurance measure, allowing poor performance in one area to be offset by better performance in another

Index funds can only be bought and sold at set prices after the market closes and the asset value is announced. If you’re investing to meet long-term objectives, this is no issue as slight fluctuations in value at different times of the day are not likely to give you cause for concern when in it for the long haul. If you are interested in intraday trading, ETFs may better suit your needs

ETFs

Exchange-traded funds (ETFs) are also popular with passive investors. Similar to index funds, an ETF is a mutual fund that tracks an index. However, ETFs differ from index funds in that they require a bit more of a hands-on approach to management. With ETFs, there is no need to wait until the market closes to trade. ETFs can be bought and sold during market hours like stocks and are bought straight from other investors—without the need for the mutual fund company to act as the middleman

An added benefit of ETFs is that they are often cheaper than index funds

Pros of passive investing

Lower costs: Passive investing often involves lower fees because there’s no need for frequent trading or expensive active management. Index funds and ETFs typically have low expense ratios

Simplicity: It’s a straightforward approach. You invest in a broad market index (e.g., the S&P 500) and hold it over time without needing to constantly monitor or analyse individual stocks

Diversification: Passive funds typically hold a wide range of assets, spreading risk. For instance, an index fund can expose you to hundreds or thousands of companies in one investment

Consistency with market returns: Passive investors generally achieve returns by tracking the overall market. Historically, markets tend to rise over time so that long-term investors can benefit

Tax efficiency: Since passive strategies involve minimal buying and selling, they generate fewer taxable events compared to active investing, resulting in lower capital gains taxes

Time-saving: Passive investing requires less time spent researching, trading, or managing your portfolio, making it ideal for those who prefer a hands-off approach

Cons of passive investing:

Limited upside potential: Since passive funds aim to match the market, they don’t outperform it. In a booming market, active investors may achieve higher returns than passive investors

Less flexibility: Passive investors are locked into the strategy of tracking a specific index, even if some companies in the index perform poorly. There’s no flexibility to respond to market conditions or trends

Vulnerable to market crashes: In a market downturn, passive funds will follow the market’s losses. There’s no opportunity to sell out or mitigate risk unless the investor takes action independently

Exposure to overvalued stocks: Index funds buy stocks in proportion to their size in the index, regardless of valuation. This could lead to increased exposure to overvalued companies

Lack of  a personalised strategy: Passive investing doesn’t allow for customized portfolios based on personal goals, risk tolerance, or market views. Everyone holding a specific index fund gets the same portfolio

Missing out on niche opportunities: Passive investors may miss out on high-growth sectors or individual stocks that are not well-represented in broad market indexes. Active managers may identify and exploit such opportunities

Passive investing is ideal for those seeking a cost-efficient, diversified, and hands-off approach, but it limits the potential for outperformance and active market maneuvering. However, there is nthing to stop you being both types of investor. You can alloctae part of your portfolio to index tracking funs (passive) and part to your choice of actively managed funds and/or individual stocks (active). as always it’s more important to have  a plan to guide your strategy that will help you make critical decisions over time, including optimising your cash flow, how much to invest, what account types to use, what investments to own, how much risk to take, and how to minimise fees and manage taxes.

Caveat emptor!