Passive investing based on indices is often used in portfolio constructions strategies
Textbook definition says passive investing is a financial strategy in which an investor (or a fund manager) invests in accordance with a pre-determined strategy that doesn't entail any forecasting.
In practical use, it’s about investing in securities or other assets that are associated with a target index in order to match the index’s strategy and provide similar returns. A few benefits making passive investing a preferred choice would be:
The biggest benefit of passive investing is lower cost. Investment-associated costs in passive investing are definitely lower compared with active investing, as the former avoids the active investment manager costs, stock research costs and associated transaction costs on frequent reallocation of the portfolio.
Indices typically follow rules-based methodologies, which have a fixed rebalancing schedule. As such, these portfolios tend to be solid, well-researched and balanced in terms of risks involved and rewards expected. This results in the low turnover of the portfolio.
Indices vary based on asset class, sectors, country bias, themes, strategies, etc. Since they are transparent in their methodologies and also share historical data, their trends can be viewed to align return expectations. Plus, such indices offer the wide gamut of choices across asset classes, sectors, countries, themes, strategies.
Fixed rules-based methodologies ensure that the indices and thereby investment strategies tracking the indices maintain a consistent approach. As passive investing follows an index, it avoids complexity to provide a straight forward solution. The investment philosophy is the same as the index attributes, and changes in the same are easily accessible via public announcements.
A passive investing strategy tends to completely eliminate any biases that can come in from the fund manager’s own attitude towards a particular security or asset class. Since there is no active management involved here, there is no requirement to track the fund manager’s style or follow his views. Merely tracking the index movements will provide information on the index performance. Set rules and methodologies for indices ensure the passive investment strategy can be aligned with the chosen index/es and their inbuilt strategies.
Passive investing can also be a great foundation for a long-term investment strategy as studies reveal that over longer period, indices performance returns tend to beat those of actively-managed funds.
Passive investing based on indices is often used in portfolio constructions strategies such as core and satellite, wherein a combination of active and passive can be used effectively to reflect portfolio investment goals.