Is Your Passive Investing Strategy Genuine or a Deceptive Mirage?

When does passive investing cease to embody its essence? Might you be deceiving yourself as a passive investor through inadvertent missteps?

The venerable Warren Buffett ardently advocates for a passive approach, asserting that many ordinary investors ought to direct their resources toward a low-cost index tracking fund. This sentiment finds resonance among numerous renowned investors.

While it holds true that a majority of prosperous investors engage in active stock selection, it remains a fact that most investors are ill-suited for the task of personally selecting stocks.

Nevertheless, this reality doesn’t deter a considerable number of individuals from attempting to do so. Yet, there exists a cohort who, confident in their acumen, opt for a contented embrace of the passive methodology.

The late John Bogle, hailed as the father of index funds, pioneered the concept in 1976 by establishing the first index investment trust under his Vanguard umbrella.

He believed that –

“The winning formula for success in investing is owning the entire stock market through an index fund, and then doing nothing. Just stay the course.”

– John C. Bogle, The Little Book of Common Sense Investing –

Passive investing, by definition, revolves around possessing the entire market and attaining the market’s return.

The accessibility of exchange-traded funds (ETFs) has significantly increased since Bogle introduced his inaugural index investment vehicle.

In the realm of capitalization opportunities, finance professionals reliably furnish products. As of 2022, the global count of ETFs stands at a staggering 8,754, a notable surge from the 276 available in 2003.

Even on the Australian ASX, a plethora of 240 listed ETFs beckons the investor’s choice. The question arises: How can there be such a multitude of index ETFs when genuine passive investing entails acquiring the market at a modest cost?

Passive Investing Into Thematic ETFs

There exists a common misconception regarding diversification in the context of ETFs. While it’s accurate that ETFs encompass a collection of stocks, many of which track specific indices.

It’s crucial to note that these indices may not always mirror the broader market index. They could, instead, align with niche categories such as specialty retail, industrials, or small industries.

The surge in popularity of thematic ETFs is notable, presenting investors with an opportunity to gain exposure to stocks within specific industries or sectors.

Investors often acquire these themed ETFs, believing they achieve sufficient diversification due to the inclusion of, for instance, 50 different companies.

True diversification, however, is only realized when the stocks within the same basket exhibit little to no correlation. Thematic ETFs can mislead investors into assuming their capital is adequately diversified, posing a potential risk.

By opting for Thematic ETFs, investors actively engage in stock selection. In such cases, one might argue that it’s more prudent to personally choose individual stocks.

For instance, if one has a keen interest in cybersecurity and contemplates investing in a cybersecurity ETF, the challenge lies in evaluating the investment potential without knowing the specifics of all the companies within the ETF.

The inherent risk emerges as there’s a substantial possibility that each company in the cybersecurity ETF is overvalued, with the likelihood that half may not endure the next year. Consequently, it becomes evident that Thematic ETFs do not align with the principles of passive investing.

Drawing A Line Between Passive and Active

The realm of investment offers an abundance of choices, and for those who prefer a hands-free approach, the appeal of ETFs is quite understandable.

Many individuals either lack the time or interest for in-depth company research, finding the prospect of delving into lengthy annual reports somewhat daunting. For such individuals, a passive investing strategy seems more fitting.

Opting for a broad-based index-tracking ETF epitomizes the epitome of passivity. However, once you venture into the realm of thematic ETFs, you transition into an active investing mode.

Investing in thematic ETFs is perfectly legitimate, but it’s crucial not to deceive oneself into perceiving it as a purely passive endeavor.

Choosing to construct a portfolio using various thematic ETFs constitutes an active approach. Why? Because you’re deliberately selecting sectors or industries that either pique your interest or align with your desire for exposure.

This approach encounters its first challenge as the stocks within thematic ETFs tend to exhibit correlation. If an issue arises within a specific industry, every stock in that ETF feels the impact.

Moreover, without insight into the companies constituting the ETF or their individual valuations, the true nature of the investment remains unclear.

A more prudent approach involves narrowing down a list of the top 10% of companies in the ETF, conducting thorough research, and valuing them individually.

If you believe you possess an edge within a particular industry and seek exposure, opting for individual ownership rather than an ETF may yield better returns. This way, you increase the likelihood of achieving favorable outcomes without relying on the kindness of strangers.

Defining The True Meaning To Passive Investing

Passive investing, at its core, involves a straightforward strategy—one where you navigate the financial landscape without the burden of constant decision-making. This entails adhering to a consistent approach, engaging in periodic dollar-cost averaging.

For optimal results, this passive strategy aligns seamlessly with low-cost, broad-based index tracking funds. These funds typically mirror major markets such as the S&P500, ASX200, MSCI Global, or the total Global Market. Investing in ETFs linked to these indices embodies the essence of passive investing.

Embracing a passive approach implies refraining from wagering on specific sectors or industries. Take, for instance, the ASX200, comprising the top 200 listed ASX companies. Historically, the Australian stock market has delivered an average annual return of 8-10%.

By investing in an ETF tracking the ASX200, you secure the market’s return. The beauty lies in the fact that the ETF’s stocks aren’t confined to a specific sector or industry, avoiding correlation and facilitating diversification across the entire market.

Opting for a market index ensures ownership of every valuable entity, eliminating the risk of missing out on the next major player. As companies grow, the index automatically rebalances, ensuring inclusion of such enterprises—meaning you won’t miss out on the next Microsoft or Amazon.

Granted, this passive approach may entail missing out on substantial gains, but it also shields you from significant losses. Essentially, passive investing embraces the concept of contentment with achieving the market return without the exhaustive effort.

Key Takeaways

• Thematic ETFs are not a form of passive investing as you are betting on a specific industry or sector
• True passive investing is buying a low cost broad-based index tracking fund that will guarantee the market return
• Passive investing requires zero to little effort

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