Understanding the Reasons of the Shift from Active to Passive Investing - WiserAdvisor - Blog (2024)

A recent report released by the Investment Company Institute (ICI) stated that passive fund investments have crossed active fund investments and reached an $11 trillion benchmark in 2020. A significant shift in investment styles can be seen across the world. Investors are slowly moving major portions of their investments from active to passive funds and abandoning fund managers. Both passive funds and ETFs (exchange-traded mutual funds) have been a preferred tool of investment ever since the year 1995.

Here are some key insights into the two investing styles:

What is active investing?

Active investing predominantly involves fund selection, market timing, stock picking, and continuously reviewing your portfolio. Active funds are primarily managed by dedicated fund managers and their teams who keep altering portfolios as per market situations and investor preferences. All investment decisions, in this case, are made by the fund manager on behalf of investors. The expense ratio is charged in return for the services offered by the manager which usually ranges between 0.25% and 2% (sometimes more) of your total portfolio value.

A major reason why people started flocking towards passive funds was that they had to pay an additional fee to the fund manager for returns that were almost similar to passive funds. In addition to this, the expense ratio seemed to be a small number initially. However, it totalled up to a considerable amount when it was calculated relative to the investment portfolio.

But active funds also offer some benefits. They are known to generate inflation-beating returns and provide the utmost flexibility to investors to shift their trades.

What is passive investing?

Passive investing is a more laid-back approach to investments where investors generally buy index funds or passive mutual funds that replicate the underlying indices. Passive investing is more about tracing and tracking. Although currently there are limited options available in passive funds, investors can choose from them and wait for the fund to touch its benchmark’s return.

Since there is no active fund management, there are no associated fees as well. Passive funds are often used by investors looking for cheaper and more transparent avenues to stock their money.

What is the difference between active investing and passive investing?

While active funds are always in a rush to outperform the underlying benchmarks and indices, passive funds only aim to imitate the returns generated by those indices. For the same reason, passive funds are cheaper and require less maintenance.

Why is there a paradigm shift in the investing style: active to passive?

The recent trends and changes in the investment ideology of people can be called a paradigm shift. Investors are adopting a smart investing style that accounts for cross-checking the fund manager’s performance, past tracks, and the overall return their portfolio can generate.

Earlier, due to a lack of resources and information, it was hard to gauge the investment routine and strategy of the fund manager. However, with plenty of facts and figures readily available now, investors have become aware of the underlying potential of their portfolio as well as their manager. Yet, several active investment enthusiasts discard any logical reasoning behind passive investing.

Benjamin Graham, known to be the father of value investing, advocated passive investing as a defensive style. According to him, investors who were not willing to put in a lot of effort and work on the active and value investing style were the ones who made the shift to passive investing. However, trends have now changed with both enterprising and defensive investors opting to move towards a passive style.

Here are some major reasons why more investors are now interested in passive investing over active investing:

1. Higher fees

Since passive funds do not require active management of investments, there is no need to hire a fund manager. This reduces the costs involved in investing. The expense ratio is also negligible in case of passive funds, making them a cheaper option as compared to active funds.

2. Liquidity and redemption crisis

In the case of active funds, investors tend to redeem their investments when the markets fall to liquidate their assets. This sudden and mass liquidation of active assets leads to a crisis for the underlying fund houses. This eventually leads to fire sales and the overall degradation of the return percentage.

3. Increasing need for managing assets

With active investing, there is always a need to manage assets, given the extreme market volatility. Since markets can be unpredictable, the investments are bound to fall apart. This requires a good understanding of market timing and the active management of assets. Relying only on the fund manager’s inputs can at times result in lower returns. It may also not live up to your financial expectations and goals.

4. Higher risk to market volatility

Although no investing style is secure from the increasing market volatility, active funds are more susceptible to risk because of direct exposure. In passive investing, mutual funds and ETFs imitate the movement of the underlying benchmark. The return expectations are set accordingly. In addition to this, since the assets are traded in the form of indexes and not directly liquidated, the overall impact of volatility is reduced.

5. Trading fee

Apart from the expense ratio that goes into managing the fund, investors bear several other expenses related to active investing. A major portion of these costs can be summed up into the trading fee.

A trading fee is essentially any amount of money or commission that investors pay to sell or purchase assets, trade them for other assets, or for conducting any other business related to active funds. There are no such commissions in passive investing.

6. Lower tax efficiency

Although in the case of passive investing only ETFs are eligible for tax benefits, there is no such provision in active investments. Investors who predominantly invest in mutual funds with a purpose to save taxes tend to choose passive investment tools like ETFs.

To sum it up

Investing in financial markets requires investors to follow a checklist. However, in the case of active funds, money, time, and effort are required in higher concentrations with a greater potential of risk. On the other hand, passive funds offer a more cost-effective approach to investing and are ideal for laid-back investors.

It is common for investors to get confused over this recent paradigm shift. You can reach out to financial advisors for better understanding on the most suitable form of investing for your portfolio.

It helps to have everything in writing. Having a clear plan of action is one of the fundamentals of having a successful outcome. With a plan of action and an accurate view of your financial goals and expectations, not only do you ensure that you stay steady along the way, but you also keep financial anxiety and insecurities at bay. Maintaining an investment policy statement (IPS) provides you with these benefits, amongst others. This document can be a roadmap for you and your financial advisor that ensures that all your terms and conditions are met when it comes to your investments.

Read on to know what an investment policy statement is and how you can write one.

What is an Investment Policy Statement?

An investment policy statement is a document that states your investment goals, targets, and expectations. It provides information on how you want to invest your money, where you want to invest it, and how much you wish to invest. It offers your financial advisor an exact vision of your goals, so that they can make crucial financial decisions that align with your requirements. In some ways, an investment policy statement acts as a rule book for your financial advisor, letting them know how they should manage your funds.

What information does an Investment Policy Statement contain?

An investment policy statement can differ for different investors based on their goals, investment strategies, and risk capacity. The statement can be divided into two parts:

• Your personal objectives and your investment philosophy
• The kind of help and guidance you need from your financial or investment advisor

The first part that lays emphasis on your personal objectives and investment philosophy and generally contains the following information:

• The aim of your investment: The goal of investing is unique to every individual. While some people are looking to grow their wealth, others are just looking for a source of secondary income to meet their routine needs. You could fall into either of these categories. You could also be investing for definite goals such as a child’s higher education, or to buy a house for yourself.
• Time horizon: This section includes the timeline of your goals and whether you are looking at short-term investment options or long-term investment options. The time horizon largely depends on your investment goals.
• Asset allocation: This part includes the composition of your investments. For instance, the percentage of stocks, bonds, real estate, mutual funds, cash, etc.
• Liquidity and income needs: This section contains information on your income and liquidity needs. For instance, many investors bank on their investments as an emergency fund. In such a case, you need to have highly liquid and easily accessible investment options in your portfolio.
• Choice of investment type: This includes your investment type, such as an actively managed portfolio or a passively managed portfolio. In addition to this, the section also includes your investment preferences such as social impact investing, etc.

The second part that talks about the kind of help and guidance you need from your financial or investment advisor generally includes:

• Responsibilities of the financial advisor: This includes the responsibilities that you want your financial advisor to undertake. For example, decisions on where to invest, the execution, keeping track of your investments, and suggesting recommendations to alter your investment strategy if your goals are not being met.
• Deciding the asset allocation: The involvement of your financial advisor in deciding the asset allocation of your investments, in stocks, bonds, cash, etc.
• Monitoring the investments: This includes responsibilities like monitoring your investments, reporting the progress and growth of your funds, managing risk, diversifying and rebalancing your portfolio, etc.

How do you write an Investment Policy Statement?

Here are the steps you can follow to write your investment policy statement:

1. Start with your investing goals

It is important to put down your investing goals along with the time horizon for each. Here’s how you can start:

• Write your investment goals: Retirement, a child’s higher education, home purchase, travel, health care, etc. are some examples of different types of goals.
• Mention the time horizon: Retirement can be a long-term However, a home purchase or saving for a child’s education can be short-term goals depending on when you start investing.
• Set priorities: The urgency of each goal can be different. Your priority also depends on factors like your family’s needs, income, age, etc.

2. Mention the responsibilities and duties of your financial advisor

This section includes the help and guidance you require from your investment advisor. For instance, recommendations, monitoring, risk analysis and management, etc. This section should also specify the amount of flexibility or control you want your financial advisor to have over your portfolio and financial decisions. In addition to this, you can lay down your expectations from your advisor here.

3. Write down your investing strategy

This portion contains information on your investing strategy. Such as:

• How aggressive you want your investment strategy to be
• The kind of investment management style you are looking for – passive or active investing
• Your risk tolerance
• The asset allocation you prefer
• Your liquidity needs

4. Include your existing investments

Adding your existing investments and savings allows your financial advisor to gauge your future needs. It also allows them to know the current worth of your investments and recommend instruments that can help you gain better returns. You can include information such as:

• Your existing retirement accounts like an employer sponsored 401(k) account, an Individual Retirement Account (IRA), a pension plan, a life annuity plan, etc.
• Your savings account like a 529 education savings plan, bank accounts, certificate of deposits (CDs)
• Your real estate investments like a house, commercial property, etc.
• Your cash reserves

5. Specify your asset allocation and preferences

Mention the percentage of asset allocation you want on your portfolio under this head, i.e., the percentage of equity, debt, and balanced funds. For instance, your asset allocation can be

• 70% equity funds
• 30% debt funds

You can also mention your investment preferences, such as whether you want more stocks or more bonds. Additionally, you can write whether you are interested in traditional real estate investments or a real estate investment trust (REIT), etc.

6. State how and when to monitor your portfolio

This section can contain a wide range of subjects for your financial advisor that may include:

• The right time to revisit your asset allocation
• The threshold to monitor the performance of your investments
• The need for annual, monthly, or quarterly reports
• The need and level of diversification

7. Determine the acceptable costs and fees

Some investments and savings accounts can come with high costs, such as administration fees, management fees, fiduciary and consulting charges, etc. Moreover, the expense ratio of an investment can have a substantial effect on the returns. You can set a benchmark for these costs and specify what is acceptable and what is not. This gives your financial advisor an idea of which investments would be suitable for your needs.

8. Set a time and threshold for rebalancing your portfolio

Rebalancing refers to bringing your portfolio back to the asset allocation as it was when you started investing. For instance, if you had 60% equity at the beginning which has increased to 70% due to market fluctuations, rebalancing your portfolio will entail ways to bring your asset allocation back to 60% equity.Not only is it essential to rebalance your portfolio from time to time, but it is also important to determine the right time for rebalancing. Moreover, fixing an acceptable range is also crucial. For instance, an increase or drop of 5% may be okay for you. However, anything beyond this should be a sign indicating the need for portfolio rebalancing.

Why is it important to have an investment policy statement?

Drafting an investment policy statement can bring you many advantages. Some of these have been mentioned below:

• It states the role of the investment advisor: An investment policy statement clearly demarcates the role of the financial advisor in your financial plans. This eliminates the chances of overstepping boundaries or not being involved enough in your investment
• It acts as a guide: The statement provides both parties – the investor and the investment advisor with a roadmap to follow. This ensures that nobody transgresses from the main motive behind your investments.
• It helps in achieving your financial goals: Writing down your goals acts as a motivator to stick to your investment strategy and make sure that you reach your financial goals in the stipulated time.
• Brings forth the need for rebalancing: The various fluctuations of the market are better adapted and incorporated in your investment approach and methods with periodic rebalancing and reassessment.

To sum it up

An investment policy statement is a vital document in your investment journey. It can act as a guiding force that gives you accurate directives to follow. This ensures that you meet your financial goals as per the time horizon you have in mind. You can stay on track with your financial targets and make the most of your time and money spent on investing. Moreover, it is not limited to only when you hire a financial advisor. You can make an investment policy statement for yourself too. The document will offer the same advantages, and you will ensure that your financial goals are met.

If you need help in making an investment policy statement or with any other investment decision, you can reach out to a financial advisor for help and guidance.