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Does Passive Investing Indicate the Use of Index Funds?

Original post by Geri Terzo of Demand Media

Historically, passive investing goes in and out of style with investors.

Passive investing indicates the use of index funds, including exchange-traded funds (ETF). Index-fund managers use benchmarks in the financial markets to set investment-return expectations. While most index funds are passive, there are some that attempt to deliver returns that are more akin to profits earned by active investors.


Passive investment managers inherited this title in response to the hands-off style in which funds are managed, according to a Stanford University report titled "Indexed Investing: A Prosaic Way to Beat the Average Investor." Index funds are run by mutual-fund managers who are hired to create returns that are comparable to profits earned by another industry benchmark. Investors can buy and sell an ETF like a stock. ETFs are passively managed indexes and are meant to imitate performance in a broader market group.


Most of the investment capital in the financial markets is under active management, according to the CBS Money Watch website. The site suggests, however, that the investment trajectory is moving towards a passive style. In the decade beginning in 2001, ETFs and index funds more than doubled their stake in the market to approximately 25 percent. In June 2011, investors withdrew $19 million from actively managed investment funds while more than $1 billion was directed into passive funds.


A July 2011 article on the Minyanville website titled "Why Do Investors Fail?", suggests that passive managers are disadvantaged in volatile market conditions in part because of fear. The nature of index investing is to remain invested and meanwhile avoid the typical fees associated with frequent trading. Investors who are in the markets long enough are likely to experience some extreme conditions when stock performance is erratic. Passive investors often copy one another and exit the markets once fear sets in, according to the article.

Active Returns

Active managers attempt to outperform the broader markets, not just perform alongside a benchmark. On average, only 30 percent of active mutual-fund managers deliver profits that are greater than those earned in the S&P 500 index, an indication of broad activity in the stock market, according to a 2011 article in Forbes magazine. IndexIQ, a company that creates ETF indexes that are meant to replicate hedge-fund performance, does not strive for passive investment returns. Instead, this firm creates indexes that apply complex strategies to generate profits typically earned by active managers.




About the Author

Geri Terzo is a business writer with over 15 years experience reporting on Wall Street. Her coverage ranges from institutional investing, including hedge funds and investment banking, to family topics and her career experience includes work for Fox Business, CNBC and "IDD Magazine." Terzo is a graduate of Campbell University, where she earned a B.A. in mass communication.

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