Passive investing with ETFs

What is passive investing?

Passive investing typically involves a buy and hold strategy.

Passive investors generally tend to trade minimally, holding onto their investments with a view of building their wealth over the long term.

Usually, the aim of passive investing is to track the performance of a market index, in anticipation that the portfolio will appreciate over time. In contrast, active investors typically aim to ‘beat the market’, a strategy which seeks greater returns, but generally involves higher investment risk.

How does passive investing work and what are passive investment funds?

One of the most common forms of passive investing is via a passive investing ETF or through building a passive ETF portfolio. An ETF is an exchange traded fund which can be bought and sold on the ASX just like shares.

Most ETFs aim to track the performance of a particular market or benchmark index, for example a broad Australian sharemarket index such as the S&P/ASX 200, or a U.S. sharemarket index such as the S&P 500 or the Nasdaq-100, aiming to replicate its return and yield.

When an index rebalances, which sometimes involves substitution of companies within it, an ETF that aims to track it will also rebalance its holdings to reflect the updated index constituents.

ETFs can track both broad benchmark indices and indices which give exposure to specific market sectors, themes, countries or regions.

For example, and ETF may seek to track the performance of:

• A country-specific index e.g. BetaShares FTSE 100 ETF (ASX: F100), which aims to track the price and income performance of the largest 100 companies traded on the London Stock Exchange, based on their market capitalisation
• A regional index e.g. BetaShares Europe ETF – Currency Hedged (ASX: HEUR), which aims to track the performance of globally competitive eurozone companies
• A global index e.g. BetaShares Global Quality Leaders ETF (ASX: QLTY), which aims to track the performance of 150 global companies ranked by highest quality score
• A market sector index, e.g. BetaShares Global Gold Miners ETF – Currency Hedged (ASX: MNRS), which aims to track the performance of an index that comprises the largest global gold mining companies (ex-Australia), hedged into Australian dollars
• A thematic index, e.g. BetaShares Global Robotics and Artificial Intelligence ETF (ASX: RBTZ), which aims to track the performance of an index that includes global companies involved in the production or use of robotics and A.I. products and services

ETFs can also track benchmark indices across various asset classes, such as fixed income, commodities, and currencies.

For example:

• The BetaShares Australian Investment Grade Corporate Bond ETF (ASX: CRED) aims to track the performance of an index that provides exposure to a portfolio of senior, fixed-rate, investment grade Australian corporate bonds
• The BetaShares U.S Dollar ETF (ASX: USD) aims to track the performance of the U.S. dollar against the Australian dollar
• The BetaShares Crude Oil Index ETF – Currency Hedged (synthetic) (ASX: OOO) aims to track the performance of an index that provides exposure to crude oil futures, hedged for currency movements in the AUD/USD exchange rate

All the above-listed ETFs aim to track the performance of the relevant index before taking into account ETF fees and expenses.

Actively managed vs passively managed funds

Actively managed funds have a professional investment manager or team making decisions about the underlying portfolio allocation.

While actively managed funds often reference a benchmark index, the fund’s objective typically aims to outperform the relevant benchmark, or ‘beat the market’.

As a result, the fund usually produces investment returns that do not reflect the performance of the relevant benchmark index – unlike passively managed funds or ETFs which aim to match the performance of the benchmark index.

Benefits of passive investing

A key benefit of the passive investing approach is that investors are generally subject to lower management fees, avoiding the more expensive fees and costs that are usually associated with an investment manager ‘actively’ managing an investment portfolio by picking individual stocks or other assets.

Passive ETFs are also a way to achieve instant diversification for your investment portfolio, because you gain exposure to a portfolio of shares in a single trade.

Contrast this with ‘stock picking’, where you invest in individual shares you think will outperform – a task that is challenging for even the most experienced investors. ETFs provide exposure to broad sharemarkets, sectors or geographic regions in one trade.

Risks of passive investing

Passive ETFs generally aim to track the performance of their benchmark index regardless of the state of the overall markets. This means that their value will rise or fall depending on the value of the underlying investments, being the constituents of the relevant index.

How to invest in passive funds

Buying and selling units in passive ETFs is the same process as buying or selling any share on the ASX.

Here is a a four-step tutorial to invest in ETFs from setting up a brokerage account to purchase.