Passive investing has grown in popularity in recent years, as more investors pour money into index and exchange-traded funds. Globally, total assets under management reached the $6 trillion mark as of 2016. That’s an increase of 230 percent since 2007, according to Morningstar.
A new report from Moody’s Investors Services suggests that the uptick in passive investing is a trend that’s likely to continue for the foreseeable future. According to the report, passive investments are expected to account for more than 50 percent of assets under management in the U.S. by 2024, outpacing their active counterparts.
Lower costs, streamlined tax efficiency and liquidity are among the primary factors driving the push towards these investments. Investors are also paying attention to the opportunity to earn strong returns with passive funds, says Nahum Daniels, a certified financial planner with Nahum Daniels in Stamford, Connecticut.
“Passive investing has actually delivered better returns over the last five to 10 years than most active managers have been able to achieve,” Daniels says, an assertion that’s borne out by data from Morningstar.
[See: 10 Long-Term Investing Strategies That Work.]
According to Morningstar’s latest Active/Passive barometer, just 12 percent of active U.S. large-cap growth funds were able to outperform their passive peers over the last decade. That doesn’t mean, however, that passive investments are appropriate for every investor. Before making a move into passive funds, there are several important considerations to bear in mind.
Look at the big picture. Ryan Nauman, vice president, product and market strategist at Informa Investment Solutions in South Lake Tahoe, California, says your investment goals and how you view the market can be an indicator of whether passive investing is the right approach to pursue.
“Investors looking to increase a portfolio’s alpha are not prime candidates for passive investments,” Nauman says. “By the same token, investors who might think a bear market or a correction lies ahead may look for active managers who have the flexibility in their mandates to take a defensive stance or increase their cash exposure to help soften the blow during turbulent times.”
In other words, if you’re feeling cagey about where the market is headed, you may have more confidence in your portfolio’s ability to ride out fluctuations when there’s a dedicated fund manager behind the wheel steering investment decisions. At the other end of the spectrum, says Nauman, are a different subset of investors.
These are investors who believe the value added by active management doesn’t offset the higher fees or that the performance of actively managed funds has more to do with luck than the skill of the individual fund manager. Todd Flynn, a certified financial planner and principal at Soundmark Wealth Management in Kirkland, Washington, says this group also features investors who are more comfortable making their own investment decisions.
“The passive strategy continues to grow in popularity, not only because of its inhererent low-cost advantage but because investors are educating themselves and beginning to embrace the essential components of building long-term wealth,” Flynn says. “Passive investing is especially suited for investors who want to take charge of their financial destiny, and not turn it over to someone else who professes to be a stock picking or market timing guru.”
Asking yourself which side of the line you fall on can go a long way toward helping you determine whether passive investments are the right move.
Be aware of the risks. Gene Neavin, senior investment analyst and portfolio manager of the Federated High Yield Trust and the Federated Equity Advantage Fund at Pittsburgh-based Federated Investors, says investors need to understand how a passive strategy fits in the context of different asset classes.
“Passive investing clearly works and serves a purpose in some asset classes, like equities,” Neavin says. “However, in smaller, less efficient asset classes, like high-yield bonds, it doesn’t work.”
Nauman says the primary risks associated with passive investments are downside and volatility. He points to the credit crisis as an example, reminding investors that more than half of the major U.S. indexes underperformed their respective asset class peers during this period.
[See: 7 Ways to Tell if a Stock Is a Good Price.]
“Active investments have the ability to provide downside protection,” Nauman says.
He says another risk lies in the expanding array of products being introduced into the passive management space. While new products mean more variety, it also creates more risk for investors who may not fully understand what they’re investing in.
Daniels says investors should carefully consider where they’re at in terms of their time horizon until retirement when assessing risk and how comfortable they are with the degree of volatility some passive investments may entail.
“The focus for retirement investors should be avoiding downside risk or losses,” Daniels says. “Retirement investors cannot afford to lose money.”
He cautions investors to remember that the market isn’t static and that passive investments may react differently under one set of conditions versus another. “Passive investing is fine when the markets are rising; however, markets are cyclical. As good as passive investing can be when the markets are up, it’s that bad when the markets fall,” Daniels says.
When that happens, investors tend to panic and rush to sell off investments. That, says Daniels is a mistake, because it may make recovering from losses more difficult.
Do your research when mixing active and passive investments. If you’re thinking of splitting your portfolio between passive and active investments, it’s important to find the right balance between the two.
“I recommend indexing about 60 percent of your equity portfolio, concentrating mainly on large-cap stocks in the U.S., Europe, Canada and Japan,” Sullivan says. “Actively managed funds can be appropriate for the remaining 40 percent, including emerging markets and some smaller company stocks in the U.S. and abroad.”
Sullivan says that in efficient markets, you’re better off using low-cost index funds. Large-cap markets in developed countries tend to be more efficient, based on the number of participants, how informed those participants are and the volume of trading. But, Sullivan cautions, you shouldn’t blindly sell off actively managed funds and buy index funds.
“Even if index funds outperform active funds, it can make sense to continue to hold an underperforming active fund if selling would trigger a large tax bill,” Sullivan says.
Flynn says when it comes to managing passive investments over the long term, investors need to keep their expectations and goals as the focal point. “When creating a portfolio that evolves from a well-constructed financial plan, most investors recognize and embrace asset classes beyond large cap stocks of the S&P 500 index, including international stocks and bonds,” Flynn says.
This inevitably means, however, that in bull market cycles, a diversified portfolio may lag behind the S&P 500, which may be more significant in certain years than others.
[See: 9 Growth Funds That Will Turbocharge Your Portfolio.]
“The challenge,” Flynn says,”is to establish a portfolio that makes sense, and then stay committed to it in all types of markets.”
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Is It Time to Jump on the Passive Investing Bandwagon? originally appeared on usnews.com
