A passive fund is an unmanaged investment that tracks a particular index and like the name implies, it is indeed passive… go figure. Passive investing or “indexing” is typically a much cheaper form of investing because there is no management or stock selection (there are also other fees associated with investing in these type of products).
Within a passive fund, your money is invested to mirror companies that are already within that index. The performance of your investment in a passive fund is tied directly to the performance of that index. ETFs (exchange-traded funds) and index funds all fall under this passive fund category.
Set-It and Forget It
Remember those cheesy infomercials back in the late 90s for that Ronco Rotisserie Cooker with the tagline “You just set-it…and forget it?” Although having nothing to do with cheaply made rotisserie cookers, passive investing does follow the set it and forget it philosophy.
Simply put, you “set” your money to track a particular index and “forget it” while your investment generally mirrors the performance of that index.
The Efficient Market School of Thought
Individuals who support passive or index fund investing typically believe that markets are efficient. Put another way, everything that there is to know about companies and the stock market is already widely available to everyone.
This efficient market causes prices of stocks to adjust to reflect a company’s true value. As a result it becomes nearly impossible for one investor to have an advantage over another. If this idea holds true then there is no point in attempting to beat the market through active stock selection.
Since there is no way to theoretically “beat the market” through active stock selection using the efficient market thought process then investments with the lowest cost become a differentiating factor that could lead to increased returns.
What are the possible highlights of a passive fund?
As mentioned before, low-cost is a draw toward a passive fund. Expense ratios (the annual cost of your investment expressed in a percentage of your investment) for most of these funds range from 0.03% to 0.50% on up.
For the sake of simplicity, if you were to invest $10,000 in a passive fund with an expense ratio of 0.10%, a meager $10 would be deducted from your account annually.
This is a hypothetical example and is not inclusive of all of the fees and expenses an investor may pay.
There are also possible tax advantages for passive funds. These funds typically limit trading to the replication of the index which they are following. This lack of trading may result in minimal taxable capital gains within your investment when compared to other actively managed funds.
An Alternative: Actively Managed Funds
The goal of a passive fund is to replicate a particular index and many of them do a great job of this. However, when you replicate an index you should receive returns similar to the returns of that index for better or for worse. It may be difficult to get higher returns than the index or cushion your losses if the index were to fall in value.
If, however, you believe that certain investors are able to select stocks that could provide greater returns and possibly reduce the level of volatility than what an index can simply provide, perhaps a post on actively managed funds may spark your interest.
The material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of Jacob Dahlstrum and not necessarily those of Raymond James. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Past performance does not guarantee future results. One cannot invest directly into an index. Diversification and asset allocation do not ensure a profit or protect against a loss. An expense ratio is not the only fee associated with investing in these products. The fees mentioned above are for hypothetical purposes only and can vary greatly depending on your individual situation.
ETF shareholders should be aware that the general level of stock or bond prices may decline, thus affecting the value of an exchange-traded fund. Although exchange-traded funds are designed to provide investment results that generally correspond to the price and yield performance of their respective underlying indices, the funds may not be able to exactly replicate the performance of the indices because of fund expense and other factors.
Raymond James is not associated with Ronco Rotisserie Cooker.
Investors should carefully consider the investment objectives, risks, charges, and expenses of mutual funds and exchange traded funds. The prospectus contains this and other information about mutual funds. The prospectus is available from our office from the fund company and should be read carefully.