This contrasts with active investing, which generally involves trying to achieve higher returns than the market.
Active investors put their money into funds run by managers who aim to skillfully pick stocks that do better than average, or to judge the best times to get in and out of different assets.
Some private investors pick stocks for themselves. That's active investing, too.
Passive progressGo back fifty years and passive investing as we think of it today didn't exist.
Tracker funds had not yet been invented. Stock market indices were available, but they were only used as benchmarks.
All investing was essentially active investing. Even if you were content to get roughly the market's return, you might have bought a basket of the biggest blue chip stocks and held them for decades, or else invested in an actively managed fund that did something similar.
Index funds were devised in the 1970s, inspired by academic research that had begun to reveal a majority of active fund managers could make no claim to market-beating prowess.
Their creators used mechanical rules instead of expensive managers to construct index-following portfolios at a fraction of the cost of active funds.
Exchange traded funds (ETFs) are the most up-to-date incarnation. ETFs are index-tracking funds, but they can be traded like stocks via the usual brokers.
Today ETFs covers all the mainstream markets and asset classes, which means constructing a diversified, low-cost DIY passive portfolio is a realistic prospect for anyone.
Passive investing tends to beat active investingYou might think passive investing sounds rather defeatist.
Why not pay a bit more to get a smarter manager who beats the market, rather than settling for average?
Unfortunately the evidence shows most active managers do not beat the market – or at least not by enough to cover their fees – and thus investors would achieve higher returns if they'd simply tracked the index.
In other words, active investors pay more but get less.
When financial firm Vanguard surveyed all the active funds available to UK investors, it found that over 10 years 70% lagged their benchmarks.
Other researchers show broadly similar findings. Data firm Morningstar reported in 2014 that overall 50% of active funds beat trackers over the past decade – a better result, but still a coin toss.
Academics have also shown that even successful fund managers' market-beating streaks don't tend to last, which means investing in funds that have been doing well recently is not a recipe for success.
Indeed, another reason to take a passive approach is to avoid the wealth-sapping bad behaviour we're all prone to, such as chasing hot performers.
Private investors tend buy funds when they're popular and the stocks they own are expensive or in fashion, and to sell them when they're cheap and unpopular.
That is a recipe for poor returns.
A passive strategy based on asset allocation, regular savings, and aiming to simply achieve the market's gains can help combat these bad habits.
Active investing and ETFsOf course, some people will always want to try to do better than the crowd, whatever the statistics suggest.
ETFs offer many ways to do this, too, enabling you to employ:
- Sector rotation strategies: Where you trade in and out of different sector ETFs to try to exploit the economic cycle.
- Theme-based investing: If you believe for instance that Artificial Intelligence and robotics is the future of humanity – and so companies operating in this area will outperform – then you can buy and hold an ETF that tracks such stocks.
- Tactical allocation: You try to buy cheaper or more promising countries or assets, and underweight more expensive ones.
- Short-term trading: For those who want to test their skills as traders, buying and selling ETFs can be cheaper than trading shares (for instance there's no stamp duty) and there can be better liquidity.
ETFs for everyoneThe passive versus active debate comes down to personal choice.
The evidence is that most people are best of being passive investors using index-tracking funds such as ETFs.
But the allure of beating the market will always attract new investors keen to seek a greater fortune.
Maybe you even do both. How? Invest the largest chunk of your wealth passive for the long-term and keep yourself a small speculative portfolio for your market call investing ideas.
Regardless of whether you’re a passive or active investor, with their low costs and ease of trading, ETFs are a very versatile tool.
How you use them is up to you!