What is Passive Investing: Meaning and History

In the world of investing, there are multiple ways you can invest. You can invest by yourself after doing the research, or you can give your money to a skilled investment manager. Whichever way you choose, at the end of the day, your aim is to maximize risk-adjusted returns.

Benchmark: Meaning and Importance

When you don’t have enough bandwidth to do your own research, you consider investing in mutual funds. But how do you gauge the returns generated by the fund? Suppose a fund manager says he has generated a 10% return in a year by investing in stocks. Is it good? You may feel that 10% is a good return, as FDs generate 6-7% returns. But what if the stock market itself has gone up by 20% in the same year? Now a 10% return looks bad. Right?

So, as we can see, you just cannot say whether the returns generated by a mutual fund are good or bad. You have to compare it with something. This something is called ‘Benchmark’. Each mutual fund has a benchmark.

You can find the benchmark of any mutual fund in the basic details tab of the overview section in shapely.

When the fund is actively managed, the manager works hard with the aim of beating the benchmark. But can all the managers do it? Well, you may feel that these managers are skilled and experienced, and most of them should be able to beat the benchmark. But that is not the case. According to the SPIVA report, more than 80% of large-cap fund managers have not been able to beat the benchmark.

Here, fund managers of actively managed funds see the benchmark as something to beat. But many of them can’t. So if you can’t beat the benchmark, why don’t you stop picking stocks and just invest in the benchmark itself? This is the core idea of passive investing.

What is Passive Investing?

Passive investing is the type of investing where investors try to generate maximum returns by minimising transaction costs. In passive investing, investors generally hold well-diversified baskets of financial assets for the long term. The most famous example of passive investing is index investing. In index investing, you don’t hire analysts, you don’t do the research, and you don’t pick the stocks. You just copy the index. You create and invest in a portfolio that replicates the benchmark. You can do index investing by investing in index funds and ETFs. But why do we do this?

The answer lies in the return profile of some widely tracked indices. Over time, markets generally post solid positive returns in the long term. For example, Nifty 50 has grown at more than 10% CAGR in the past 15 years. Just by investing in Nifty, you could have comfortably generated inflation-beating returns. So, passive investing (investing in the benchmark) is not a bad idea after all.

History of Passive Investing

Before 1970, fund management was dominated by active fund managers. They all charged decent fees for their services. By the 1970s, it was increasingly clear that active fund managers, most of the time, underperformed their benchmarks. 

This led to the emergence of a new investment model. The idea was to keep the strategy simple and costs low. Why use the index just as a benchmark? Why not track that index?

This was the birth of passive mutual funds. The first index fund (First Index Investment Trust, now Vanguard 500) was created in 1976 by John Bogle. More than 17 years after the first index fund, the first exchange-traded instrument was created.

In 1993, Standard & Poor’s Depositary Receipts (SPY) was launched to track the Standard & Poor’s 500 Index, and it remains one of the largest ETFs in the world.

ETFs as an investment vehicle are also gaining popularity in India. We will discuss more about this in our next article.

FAQs

What are the benefits of passive investing?

There are many benefits of passive investing. Some of them are low transaction cost (because of less buying and selling), visibility (funds are invested in a widely tracked instrument), and ease of implementation (extreme research is not involved).

Why can’t many large-cap fund managers beat the benchmark?

The 2 key reasons for the underperformance of actively managed large-cap funds are mentioned below.

• Active management can lead to higher costs (transaction cost, management cost, etc.) and lower returns.
• These funds have a limited selection universe (top 100 companies by market capitalization). Also, they have to invest a minimum of 80% of the money in large-cap stocks.