Don’t forget there are problems with passive investing.

Passive investing has been in the news lately because more and more investment funds are being placed in passive investments.

Assets managed by passive funds rose 18 percent last year, according to Morningstar. Assets managed by active funds increased just 4 percent in the same period.

Institutional investors such as large pension funds are also placing more of their money under management in passive strategies. Seventy-nine percent of institutions used active strategies in 2012, reports Greenwich Associates. But three years later, the figure had dropped to 67 percent.

These inflows and changes in investment trends are gradually making passive investing more dominant than it used to be. Moody’s estimates that passively managed investments may make up more than 50 percent of all investments by 2024.

What Is Passive Investing?

Before we go on, let’s be clear on what both passive investing and active investing mean. The terms do not refer to an investment style. They refer to a method.

In passive investing, funds are invested in an index or a basket of stocks such as an exchange-traded funds (ETFs). Investors may purchase a fund that tracks the performance of the S&P 500, for example. No single investment manager is reviewing and choosing stocks in the fund based on his or her assessment of their performance and potential. They are buying every stock in the S&P 500 to replicate its performance, or buying one of the funds that do.

The “passive” refers to the fact that the fund is not actively managing what’s in their funds. They are simply replicating a larger group of stocks. This is true whether the basket of stocks are all stocks in the banking sector or all stocks in the gold sector. As long as they are replicating an already-existing group of stocks, they are passive investments.

The counterpart to passive investing is active investing. In an actively managed fund, a fund manager pours over financial information and makes a judgement about which stocks to buy. Generally, they do not use passive investment funds, but purchase a specific group of stocks and bonds they decide upon.

What It Isn’t

Investors may hear a term like “aggressive investing” used and believe it is a synonym for active investing. It isn’t. Characterizing investments as aggressive is a style. Aggressive investing means the investor wants the highest return possible and may, for example, choose to invest in high risk start-ups in the hope the stock of such companies will give very high returns at some point. Aggressive refers to the risk versus reward trade-off and its role in outperforming the general market.

Similarly, “conservative investing” is not some sort of synonym for “passive investing.” A more conservative investor wants a very low risk versus reward profile. They don’t like risk! But they would like some reward in stock price appreciation or dividend yield. A conservative investor may, for example, choose bonds or stocks with high dividends. They are hoping for a maximum return with very low risk potential.

3 Problems with Passive Investing

Despite its popularity, there are several issues with passive investing.

  1. Passive Investments Can Drop as Well as Rise

Many observers think the climbing popular of passive investments is occurring because the markets have done quite well since the Great Recession. Major indexes like the S&P 500 and the Dow Jones Industrial Average has risen robustly on average since the end of 2009.

Stock market averages can also drop, however. When they do, passive investors will ride their indexes or baskets down just as they rode them up. An actively managed fund, by contrast, puts thought and attention into 1) protecting against downside and 2) choosing stocks that have the best chance of going up, regardless of where they are in an index.

  1. Passive Investors Can’t Beat the Market

Many investors go into the stock market hoping to beat the market averages. If the S&P 500 returns 12 percent in a year, for example, they hope to make 14 percent. If their passive investment is, say, healthcare stocks, and a basket of healthcare stocks makes 20 percent, they hope to make 23 percent. Over time, those gains become significant.

Passive investments can’t beat the market. They are the market.

  1. Good Investing Is Complicated

Passively managed funds require no expertise about the markets they cover. In fact, they can literally be done by a robot.

But active management by people who really know an industry can result in much higher returns. If you are investing in oil stocks, for example, the expertise in comparing royalty and working interests in oil investing can lead to a much more sophisticated understanding of a company’s financial picture. The more sophisticated the picture, the more active management can forecast which stocks will do well and which won’t. The same with a sector like biotechnology. An aggressive investor focused on the merits of a therapy can predict much more accurately whether the stock is likely to do well.

Despite the popularity of passive investing, it is not always the best strategy. Passive investors may get a rude awakening if the market ever drops. They also can’t expect market-beating returns. Finally, the more expertise that goes into picking a stock, the better.

Source: Kayla Matthews. Freelance blogger and technology writer