We have all heard of him, the world’s most famous and successful active investor — Warren Buffett. And yet, he has famously recommended most investors to passive investing instead. Why is that?
In this article, we revisit the history of passive investing, and the reasons why it can be a winning strategy for long-term individual investors who don’t have time and resources to track and monitor their investments 24/7.
What is passive investing and the history of the index fund
Passive investing refers to the strategy of buying index funds (also known as tracker funds)that mirror the holdings of market benchmark indices such as the S&P 500 or MSCIACWI.
An index or tracker fund is designed to be a passive investment that mimics the performance and composition of a financial market index. It can come in the form of a mutual fund — known also as a unit trust — or an exchange-traded fund (ETF). The objective is to match or track very closely the performance of the indices,which can be broad market indices or narrower sectors such as small-cap stocks or other specific industries or themes..
The first index fund was created by John ("Jack") Bogle, the founder of asset management firm Vanguard. He revolutionised investing with his philosophy and belief that to succeed in investing, investors should buy exposure to the entire market, rather than stock pick. That's how the trillion-dollar passive investing industry was born.
The Vanguard 500 Index Fund has been tracking the S&P 500 consistently. As of March 2023, Vanguard’s Admiral Shares posted an average annual return of 7.12%, close to the S&P 500’s 7.13%.
Mutual funds and ETFs are very similar in the way they offer diversification of stocks and can both suit the long-term investor.
ETFs can often be traded like a stock throughout the day on a stock exchange. On the other hand, mutual funds trade at the net asset value of the fund, which is based on the day’s market closing price, and can appeal more to long-term investors who do not need intraday liquidity.
In some instances, unit trusts may be more expensive than ETFs — but this is not always the case. There are in fact lower-cost share classes for unit trusts, with management fees that are in line with or below ETFs for similar or better-implemented exposure. It is important to understand the fees involved for ETFs and mutual funds.
Another big misconception is that all ETFs are passively tracking the markets while all mutual funds are actively managed. The truth is, there are numerous ETFs that are not indexed or traded actively, and many also track different sub-sectors of a single country’s market. At the same time, there are also unit trusts that are passive indexed funds.
Read more: ETF vs mutual fund — which is better?
Why have passive investing form a core part of your portfolio
You might ask: “Why should I invest at all?” After all, saving your money essentially guarantees that you will not make any losses, whereas investing comes with risks.
Indeed, savings can provide a safety net when it comes to unexpected expenses, and they also lay the foundation for building your wealth. But by itself, saving is unlikely sufficient in the long run to beat inflation nor prepare you for long-term life goals such as retirement.
Passive investing in particular also lowers your risk as it spreads your investments across a mix of asset classes, industries, and geographies, instead of an individual stock.
Lately, investors have also switched into passive investing as investment returns of active equity fund managers have consistently trailed those of passive funds over the long-run.
Moreover, index funds tend to charge lower fees than actively managed funds. This difference in fees can have a significant effect on investors’ returns when compounded over longer time frames.
Take an example of a HK$100,000 investment. Let’s say two funds both have earned you 7% per annum (a good return), but one is an active fund which charges a relatively high fee of 1.75%, versus an index fund which only charges 0.75%. In 30 years, the 1% in cost difference will deprive you of 152% in returns or HK$152,000 — that’s a loss worth more than your original initial investment!
We all have heard of the power of compounding, but besides returns, fees can also compound and eat into your returns.
The debate of passive vs active, again
The market volatilities of 2023 reignited the narrative that active funds might serve investors better in navigating market turmoil than passive peers. Morningstar revised the issue again and provided an updated analysis in June 2023. Interestingly, in light of market volatilites, active funds did "roar back to life" briefly, with 57% of active funds managed to outperform their average passive peers in the first half of 2023.
However, for long-term investors, the issue lies in looking out at a longer-term horizon — with only 9% of USlarge cap active equity managers managed to outperform the average passive peer over a 10-year period until June 2023.
Hence, for long-term core investments — such as your retirement fund — you can consider applying a passive investment strategy to maximise your chance of investment success while reducing the stress in having to do tactical active investing.
Of course, there can surely be outperformance for select top-tier active managers. According to Morningstar's analysis, it also show that for more specialised segments such as small-cap, real estate and fixed income, active managers have a higher chance of outperforming passive peers. Hence, to complement your core portfolio, you can also consider exploring market trends and themes with smaller portfolio allocations (such as smart energy or food & nutrition).
This is what we call a core-satellite allocation strategy and there are more than 200+ Best-In-Class funds and model portfolios you can select from to implement your own core-satellite strategy.
Read more: Core-satellite investing with Endowus
To get started with your Endowus investment journey, click here.
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