Wouldn’t it be fabulous if you didn’t have a business but still make money regardless of whether you were working, sleeping, or even relaxing on the beach?
Making your money work for you 24/7 is a frugal savers’ dream. Unfortunately, even the highest savings interest rates of 5.5% couldn’t overcome our country’s inflation rate, which was 6% as of June 2023.
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One of the most common reasons for investing our money outside of savings is to beat inflation. However, not everyone has the time to actively manage their investments. Fortunately, passive funds have grown and improved through the years and it’s much easier now to get into passive investing.
What is Considered Passive Investing?
The idea behind passive investing (aka passive management) is that the market will go through dips and bumps in the short term, but in the long run, it will inevitably go up. A common strategy for passive investors is to build wealth gradually and model their portfolios after the market’s performance rather than attempting to outsmart it.
Passive investors use the buy-and-hold investment strategy when they purchase and maintain ownership of a diversified portfolio of assets, which is often based on a wide market-weighted index. The objective of a passive investment strategy is to duplicate the performance of the financial index as a whole, with the intention of not outperforming but rather matching the market.
Passive Investment Examples
Now that we’ve established that you can make money with little to no ongoing effort if you have passive income, let’s take a look at some passive investment examples.
In Australia, there are two main ways to generate passive income: shares and property. You might consider a variety of various investments and techniques within these categories.
To generate passive income through shares, investors focus on long-term, stable investments with consistent and moderate capital growth over time. Quick gains are not a reliable strategy for wealth building.
Aside from the potential for capital appreciation if the share value rises, you can also earn passive income through dividends. If the company you invest in distributes dividends, these are usually paid twice a year.
Holding shares for passive income offers minimal ongoing costs, typically attracting just a brokerage fee for trading. However, investing involves risk. If you lack confidence in selecting shares as an investment or determining if share investing is suitable for you, seeking independent financial advice or exploring managed funds could be a wise option.
Investing through a managed fund (aka mutual funds in the US) is another possible way to get passive income. A managed fund invests your money – along with that of other investors – in assets like shares, bonds, real estate, or cash by pooling it with other investors’ money. Typically, there are costs associated with investing in a mutual fund.
You own “units” in a managed fund when you make an investment. The unit’s value will fluctuate based on the market value of the assets in which the fund has made investments. Some managed funds pay income (referred to as “distributions”) in addition to capital gain if the unit price rises.
Managed funds can either be actively managed or passively managed. Actively managed funds need a hands-on approach where active managers choose how to invest funds. In contrast, passively managed funds often follow market indices.
An index is a collection of financial assets grouped together based on criteria and importance, providing a way to track and measure different segments of the financial markets.
A benchmark index can focus on industries, investment themes, international markets, local markets, or emerging macro trends, and are available for bonds, commodities, currencies, and even cryptocurrencies.
Index Funds are managed funds that follow a particular market index.
In an index fund, the fund managers select shares based on a stock market index, such as the ASX 200, instead of hand-picking individual stocks for investors. This means that if a share is added or removed from the ASX 200, the index fund managers will mirror that change in the fund’s shares.
The appeal of index funds lies in their simplicity. They typically have lower fees since passive managers don’t have to engage in extensive research and decision-making. As a result, investing in index funds can be a cost-effective option for investors. Essentially, any type of fund can be an index fund depending on the passive strategies employed by the index fund managers.
Exchange Traded Funds (ETFs)
Exchange-traded funds (ETFs) provide a low-cost way to earn returns similar to a specific stock market index or commodity, and they can help diversify your passive investments.
ETFs are funds that can be bought or sold through a stockbroker on exchanges like the Australian Securities Exchange (ASX). You get to own units in the fund, while the ETF provider holds the underlying assets. The value of ETF units closely follows the net asset value (NAV) of the ETF, making them different from individual stocks, which fluctuate based on demand.
ETFs can be passively managed, tracking an index or commodity’s value, or actively managed, employing high-risk strategies to outperform an index. They can be physically backed, investing in all or a sample of assets in the index, or synthetic, using derivatives to mimic the index’s movements.
Various asset classes can be accessed through ETFs, including shares, sectors, fixed income, precious metals, commodities, currencies, cryptocurrencies, and diversified portfolios.
A freestanding property investment, such as a house, is a wonderful option since you own the land and the value is in the property, not the building. This option offers greater control over the property’s management compared to buying an investment apartment or townhouse.
If the property is positively geared, you can receive rent as passive income. However, if you still have a home loan on the property, you need to divert sufficient rent to pay off the loan before claiming any income.
Another type of property option is investing in a strata property, such as a unit, apartment or townhouse. With strata, the most that you might have to do is join the body corporate and manage it that way. However, you only own a portion of the land outside of your lot.
How much you could claim as a passive income would again depend on the costs associated with owning the property, such as repaying an investment loan.
Property investments often involve ongoing costs like maintenance, repairs, home insurance, and property management fees. Investors may also face additional taxes like stamp duty, land taxes, and government fees. These costs can be significant compared to other asset classes like direct shares.
Real Estate Investment Trusts (REITs)
Publicly traded firms called REITs invest in real estate, which includes structures like office skyscrapers, shopping centres, warehouses, hotels, and movie theatres. They are pooled investments that are supervised by a professional manager, similar to managed funds.
Despite having real estate as their backing, REITs behave more like shares because they trade on the stock market and have greater exposure to commercial real estate. With the option to purchase and sell shares in real-time on the stock market, REITs have risks that are comparable to shares.
Is Passive Investing Better Than Active Investing?
Investing involves a lot of factors. An investor must consider personal financial circumstances, risk tolerance, and time horizon. One way to compare passive investing with active investing (aka active management) is through the SPIVA Australia Scorecard.
The scorecard compares the performance of actively managed Australian funds to their respective target benchmarks over different time periods. It covers large-, mid-, and small-cap equity funds, real estate funds, and bond funds, and it gives statistics on outperformance rates, survival rates, and the spread of fund performance.
Overall, active funds underperformed against their target benchmarks in 2022, with the underperformance rate being even higher over the longer term.
Australian Equity General funds had a full year underperformance rate to 57.6% against the S&P/ASX 200. Even more funds underperformed over longer time periods, with 81.2%, 78.2%, and 83.6% of funds doing so over 5-, 10-, and 15-year time periods, respectively.
Australian Equity Mid- and Small-Cap funds had an underperformance rate of 80% against the S&P/ASX Mid-Small in 2022. Small and mid-cap funds did better in the long run, with only 54.7% underperforming over a 15-year time.
In 2022, International Equity General funds underperformed the S&P Developed Ex-Australia LargeMidCap by 56.3%. More than 86% and 95% of funds underperformed over the 5- and 10-year periods, respectively.
In Australian Bonds funds, 69.2% of active funds did worse than their S&P/ASX Australian Fixed Interest 0+ Index benchmark. Over the longer term, active funds did about the same: 66.1% and 79.3% underperformed over 5 and 10 years, respectively.
Active managers in the Australian Equity A-REIT funds had their lowest underperformance rate with only 41.2% of funds underperforming the benchmark S&P/ASX 200 A-REIT. Over longer time periods, underperformance rates reached 79.1% over a 15-year horizon.
Although past performance is no indicator of future performance, the data shows that tracking a benchmark index is generally more advantageous while requiring less skill than active investing.
Difference Between Passive and Active Investing
Passive investing has gained in popularity through the years because of its ease of investing and consistently outperforming actively managed investments.
But that doesn’t mean that active investing isn’t here to stay. Some investors still choose to actively invest. To understand why, let’s check the difference between active and passive investing and revisit the goals of each.
The Goal of Passive Investing
Passive investing aims to replicate the performance of a specific index or indices (before fees and expenses). For instance, if an index tracking Australia’s top 200 companies increases by 10% in a year, an exchange-traded fund or passive fund seeking to mirror that index would generally expect to yield a similar return.
Passive investing offers several compelling advantages due to its hands-off approach, but it also comes with some disadvantages:
Competitive Fees. Passive funds and ETFs typically have lower fees compared to active strategies that aim to outperform the market or a particular benchmark.
Increased Transparency. Passive funds provide daily disclosure of their holdings and usually adhere strictly to the index they track, offering greater transparency compared to many active funds.
Can’t Beat the Market. Passive investors aim to achieve market returns, so they won’t beat the index or achieve above-average performance.
Limited Strategies. Passive funds may not have access to complex techniques like short-selling specific companies, which some active funds can utilise.
The Goal of Active Investing
Active investing follows a hands-on approach, where investors or professional fund managers strive to outperform a benchmark index by utilising diverse strategies.
Some active managers conduct extensive analyses of company aspects, conducting site visits and meeting management teams to determine which stocks will perform better. Others rely on proprietary trading algorithms that consider various factors to buy and sell shares.
Active investing doesn’t rely on gut feeling – it has a scientific approach that offers benefits for short-term traders that passive investing can’t match. However, this comes at a price and a common risk it shares with passing investing.
Flexibility. In contrast to passive investing, active investors do not have to follow the performance of a specific index and hold the securities within it. Instead, they aim to select investments they believe will outperform others and avoid those with potential poor performance.
Use Various Strategies. Active managers have more flexibility in using various strategies and financial instruments such as short-selling and derivatives to protect against losses or generate higher returns.
Higher Costs. Active investing, whether self-managed or done through a professional, is generally more costly. Active investors tend to engage in more buying and selling or frequent trading. Also, an actively managed equity fund usually has higher fees compared to an index fund or ETF.
No Guarantee. Despite the higher costs, there is no guarantee that active investing will result in better performance. In fact, an active manager might significantly underperform the relevant benchmark or index, while investors still have to pay higher fees.
While costs are essential considerations for all investors, individuals should carefully assess their personal circumstances and choose strategies that align best with their goals and preferences.
Passive Investing Strategies: Should You Try It?
Passive investing is essentially a buy-and-hold strategy, a long-term approach in which long-term investors do not trade frequently. Instead, they acquire and then hold a diverse portfolio of assets.
Buying an investment property and investing in a market-linked index fund are two of the most common passive investing strategies.
Advantages of Passive Investing
Instead of making a quick buck, the ultimate purpose of passive investing is to build wealth gradually. Here are the key characteristics of a passive strategy:
Positive Outlook. The essential idea of passive investment strategies is that investors can expect the stock market to rise over time. An investment portfolio that mirrors the market will appreciate along with it.
Minimal Charges. A passive strategy has low transaction costs due to its slow and steady approach and a lack of frequent trading. While management fees levied by funds are unavoidable, most passive funds typically keep charges far below 1%.
Diversified Portfolio. Passive strategies also give investors an efficient and low-cost opportunity to diversify. Because index funds own a diverse range of securities from their target benchmarks, they spread risk broadly.
Lower Risk. Diversification almost always carries less risk by nature. Investors can diversify their holdings even more within sectors and asset classes by selecting more specialised index funds.
Disadvantages of Passive Investing
Although there are a great many advantages to passive investing, there are also some disadvantages associated with passive investment strategies.
Rise and Dive with the Benchmark. Index funds always track their benchmark index, no matter what is going on in the markets. They will rise when the index is performing well, and they will fall when prices fall.
Lack of Versatility. Even if index fund managers anticipate a decline in their benchmark’s performance, they often are unable to take actions such as reducing the number of shares they own or taking a defensive, counterbalancing position in other assets.
Average Gains. Passive investors are unlikely to profit from the significant returns that actively managed funds can occasionally provide because passive funds aim to mimic the market. Even if a fund did catch a rising star in the index, the returns would be offset by the fund’s other holdings, so the fund would benefit less.
Less Risks, Less Returns. Buying and holding can be a profitable strategy over time. The long-term strategy can weather market volatility. However, levelling out the risks flattens out the gains. Active investment could potentially produce better results and larger gains over shorter time periods.