How A Passive Investment Can Complement Your Portfolio

Passive investment has been hailed as the new dawn of investing. It has been suggested that managed funds will disappear over time, due to passive investment strategies. This is due to the inability of many portfolio managers to outperform their benchmarks over time, as well as the cost efficiency of passives. 

Takeaways

• Different types of passives

• Risks to watch out for when investing in passives

• How to use them to complement your portfolio

What is passive investment?

Passive investment in investing in something which is left to its own devices. This explanation is slightly misleading as no investment should be left to it own devices. Although we are not suggesting you watch the daily movements in the value of your stock portfolio, keeping an eye and regular reviews of your portfolio is sensible. Ideally this would be 2/3 times a year.

Today's choice of ETFs is huge.

Today, passive investment is the use of ETFs which track stock markets, sectors, asset classes and even esoteric parts of the investment universe. As the market's direction is unpredictable, trackers are attractive because you will never lose out on a market rally. Whether the market you are invested in goes up or down, your tracker will follow it. Some investors regard alternative investments such as wine investing or coin collecting as "passive investments".

With managed funds, a human makes the decisions and invests in the areas they think are best. If they get it wrong you have an opportunity lost and are immediately behind. It does not help that those who are supposed to make money in all markets, such as hedge fund manager, can also get their fundamental analysis completely wrong.

Different types of passives

The basic passive is one which tracks a main market such as the FTSE 100, S&P 500, Dow Jones index or Stoxx 50. These replicate the markets they track, namely hold exactly what those stock markets hold.

You then have passives which track sectors, for example the tech or healthcare sectors. Finally you can have passives which thematic investing focused investors will enjoy. These will can be trends such as renewable energy or electrical cars, such as Tesla stock.

Investors need to pay attention to the make up of the ETF they are using to passively invest. Basic ETFs will buy the underlying holdings they own, this applies to mainstream ETFs tracking core markets. Other ETFs, notably in the commodity space will use derivatives - which can cause problems.

Passive investment risk

Passive investing is not without downside risk. Indeed there are also criticisms of investing in passives. An ETFs which replicates a stock market or sector will track the winners and also the losers. This means you will also enjoy all the prospective benefits of undervalued stocks but also the negatives of overvalued stocks.

Indeed this risk can become real with trackers which use derivatives. The USA oil fund which tracks the West Texas Intermediate oil price uses derivatives to gain its exposure. This can create problems. Commodity ETFs either have to buy and hold the commodity, at great cost, or use derivatives, which are cheaper and theoretically more nimble. As a result many commodity ETFs use derivatives with the associated risks this creates, such as highlighted above. But there are other risks. It has long been suggested that ETFs are getting too big and can become unwieldy in volatile times which preceds a crisis.

Exactly this happened in the coronavirus March 2020 sell off with bonds ETFs. The price of bond ETFs versus the underlying value they track, widened in an unexpected manner. Although some ETF providers put out beautifully worded explanations of why these differences were nothing to worry about, you should be aware this can happen.

How to use passives

Although the risks highlighted above may create some trepidation within some of you, passives have a role to play in your portfolio. In a world where it is easy to make a foreign portfolio investment, you should own ETFs which track the main markets in the world: FTSE 100, S&P 500 or Stoxx 50. As most benchmarks are compared to them, you will rarely lose out on performance.

ETFs tracking a sector can be very profitable.

At times though, an entire market can be propelled by a couple of sectors. After the Coronavirus sell off of 2020, markets rebounded led by healthcare and technology stocks. Anyone who had bought ETFs tracking these sectors would of made a lot of money.

Finally ETFs can be used to track megatrends which are clearly on the up, but it may be unclear which company will the best to back. For example, areas to focus on today would be renewable energy, environmentally friendly companies, cloud computing/homeworking and video games.

Conclusion

Whether you are an experienced investor in ETFs or a complete novice, avoid using leveraged ETFs as the risk of them blowing up in your face is simply too big. Something else to be aware of, you can even save stamp duty on shares by using passives.

Although many managed funds have got away with murder, ETFs should not be seen as a replacement but as core holdings which will compliment your portfolio.