Passive Investing – Definition

Cite this article as:"Passive Investing – Definition," in The Business Professor, updated April 5, 2019, last accessed October 19, 2020, https://thebusinessprofessor.com/lesson/passive-investing-definition/.

Back toINVESTMENTS TRADING & FINANCIAL MARKETS

Passive Investing – Definition

Passive investing is an investment method characterized by holding assets for longer terms and very little buying and selling of securities.  It is also referred to as a “Buy and Hold Strategy”. Generally, this is done by purchasing an interest in a group plan of index that tracks the portfolio or weighted index in the market. It is a common practice in the equity market. It is becoming more popular in other types of investment, such as hedge funds, commodities and bonds.

A Little More on What is Passive Investing

Passive Investing strategy maximizes performance by limiting fees. The goal of Passive Investing is building wealth and resources gradually. The passive investors seek long-term value, and do not seek to earn profits from the short term fluctuations of the price or market timing. Just like assumptions in all economic models, the Passive Investment Strategy assumes that the market will produce positive returns with the passage of time.

Passive investors know that it is difficult to time trades and make profits. So, the passive investor generally invests in a balanced portfolio of funds that matches the investors risk profile.  Index funds and Exchange Traded Fundes (ETFs) in particular have made it possible to achieve returns more easily in line with the stock market. Keeping a versatile portfolio is significant for a successful investment.

By not purchasing and selling securities, fund managers reduce operating expenses in comparison to actively managed funds.

The effectiveness of passive investing depends on overall market risk. The primary risk to the investor is overall market risk. Another disadvantage, managers of index funds are generally do not making use of defensive measures, such as decreasing the shares position,

References for Passive Investing

Academic Research on Passive Investors

•    Passive investors, not passive owners, Appel, I. R., Gormley, T. A., & Keim, D. B. (2016). Journal of Financial Economics, 121(1), 111-141. Passive investors are a significant component of the United States stock ownership. This paper investigates how they affect the governance of the firm. They exploit changes in ownership by passive funds linked to stock allocation of Russell indexes 1000 and 2000. They result in equal voting rights, independence of directors and takeover defences removal. Passive ownership is linked to improvements in the long term performance of the firm.

•    Sovereign wealth funds: active or passive investors?, Rose, P. (2008).  The government created SWFs (Sovereign Wealth Funds) for investing the additional funds in the private markets. Today, they are getting importance worldwide. The economic powers of the SWFs is measured in trillion US dollars. These funds will be used politically and effectively. Now, the fear spreads that SWFs is going to be used as a political instrument. Is this a justified fear? The answer is definitely no. There is no evidence that SWFs will control US firms. In fact, the regulatory and US political constraints will pressurise to shun control and in their portfolios, avoid having an effect on the US companies.

•    Venture capital funds, organizational law, and passive investors, Gulinello, C. (2006). “Alb. L. Rev., 70, 303. This paper throws light on the importance of venture funds in Passive investing. What is the organisational law in this regard and what can the Passive investors gain by following it.

•    Noise trading and market efficiency: The role of passive investors, Tokic, D. (2007). The Journal of Trading, 2(3), 37-44. Because of fairly high agency costs, the Passive investors are engaging in the speculative activities and positive feedback trade as compared to the real strategies of passive investment. Consequently, all other contributors to the market, are engaging willingly or unwillingly in some types of positive feedback trade. It will produce highly large bubbles. The authors give an argument that the doubtful behaviour of passive investors is the main reason for markets’ inefficiency.

•    Defined Contribution Plans for Passive Investors, Choi, J. J., Laibson, D., & Madrian, B. C. (2004).  In this article, the authors present the defined contribution plans related to Passive Investors. What advantages they have and what they should avoid doing.

•    Do Passive or Active Investors Make Better Asset Allocation Decisions?, Blanchett, D. M. (2010). The Journal of Index Investing, 1(2), 74-80. The investors of mutual funds show the allocation of their assets by their fund flows or investment dollars. They act to be smart because the temporary performance of funds experiencing inflows is much better as compared to the performance of funds experiencing outflows. In further studies, it was found that the investors of mutual funds act to be dumb. This is because retail investors minimize their wealth for a long time. They re-allocate across various mutual funds. The findings of this paper are, when we rank net flows and sort them for all type of active, passive funds, in the 9 domestic equity style, both investors are smart for a short time.

•    Investment Behavior of Active and Passive Investors: A Comparative Study of Kuala Lumpur Stock Exchange Individual Investors, Ghazali, E., & Othman, M. N. (2001). In Proceedings of the Asia Pacific Management Conference (Vol. 607, p. 622). This paper is an examination of active and passive investors’ behaviour in the KLSE (Kuala Lumpur Stock Exchange). The sample contained 240 KLSE individual investors from Petaling Jaya and Kuala Lumpur. Their age ranges from 26-49. The number of male respondents was larger than the females by 3 to 1 ratio. The active respondents were about 37%. They were normally weekly or monthly shareholders. The passive ones were 63%. They held shares for a year or more. There were many differences found. For them, brokers and remisiers were a great source of information.

•    Passive Investors, Active Traders and Strategic Delegation of Price Discovery, Jezek, M. (2009).  There is no theoretical or empirical support found for the Rational Performance Chasing Equilibrium Model. A more accurate framework of market dynamics is subject to investor confusion. The incentive structure of this model is fragile. It is not robust. More rationality refers to more passive investing which is not knowledge based. As a result, it may cause less efficient pricing. The real resources are likely to misapplication. The current index products growth may continue as no limit is there on it.

•    Passive investors, Nathan, S. (2013). Personal Finance Newsletter, 2013(392), 11-12. This research is carried out to highlight the role and importance of passive investors. What kind of strategies they adopt and how they bring the prices up and down according to the market conditions.

•    Passive investors are passive monitors, Heath, D., Macciocchi, D., Michaely, R., & Ringgenberg, M. (2018). Available at SSRN 3308362. The passive index funds, today, own almost more than twenty-five percent of the ETF assets and the United States mutual funds. With the help of index reconstitutions, the authors imply passive investing by checking directly the exit and voice mechanisms. Index funds tend to vote with the management of a firm. In addition, they do exit positions on a regular basis and in target benchmarks, forget holdings. To apply fair governance, they do not get the help of the exit mechanism. The passive investing transfers power from investors to the managers of the firm.

•    Passive Investors, Corporate Governance, and Firm Performance, Qin, N. Corporate governance theory suggests that organizational investors can efficiently make the governance quality better by the threat to exit. However, passive investors have no ability to exit, hence lowering the governance quality of firms. This study proposes statistical evidence in favour of this hypothesis. Passive investors’ high ownership is relevant to the lesser firm value which is measured with the help of Tobin’s Q. Passive investors have a negative impact on corporate governance. They minimize board independence by increasing the probability of duality of CEO-Chair.

Was this article helpful?