For those interested in the extensive research behind passive and index investing, this is the place to be. Here we offer a brief primer about the most important research of the past 60 years and the practical application of that research for investors.
Passive investing is a financial strategy that attempts to match, rather than beat, the performance of the market. Within an equity portfolio, passive managers start with the entire universe of stocks that are eligible to trade, then sort them according to large and small cap, value and growth fundamentals. They don’t make investment decisions based on forecasts, market timing or economic predictions. They don’t choose one stock over another. A passive manager seeking to capture the returns of U.S. stocks doesn’t care if Coke is preferable to Pepsi, if Microsoft is preferable to Google, or if the economy is expanding or contracting. Instead, passive managers accept that markets are efficient (that is, they quickly adjust to new information) and prices are fair.
Passive investment advisors build portfolios based on proven principles of asset allocation, using low-cost index funds. Index funds offer the advantages of low operating and trading expenses, excellent diversification within asset categories, and broad access to all segments of the market.
Index fund managers construct portfolios to closely approximate the performance of well-recognized market benchmarks. They buy and hold stocks in the same proportions as they exist in the market or particular market sub-category; for instance, the S&P 500 index (large U.S. companies), the Russell 2000 Index (small U.S. companies) or the Morgan Stanley “EAFE” index (large international companies). Other well-known indexes measure small company stocks, high-book-to-market company (value) stocks, emerging market stocks, foreign stocks, real estate securities, precious metals, gold, commodities and an array of taxable and tax-exempt fixed income strategies. The result is a portfolio with hundreds or even thousands of stocks.
The most important decision for a passive investment advisor is determining the proportion of stocks to bonds in any given portfolio. The next consideration is determining how to divide stocks; for instance, small and large, domestic and global, emerging markets or developing markets, value or growth. When applied to an investment portfolio, passive investing means investing in a mix of asset classes, via passive strategies, that capture broad market exposure and control risk.
Please note: For an important discussion about Dimensional Fund Advisors’ alternative approach to passive investing, please read Preferred Funds.