The Keys to Passive Investing

On 11/02/2010, in Investment Strategies, by Jordan Wilson

Okay, so hopefully we agree that passive investing is generally the best route for individuals wanting to invest over the long term.

This post outlines the steps to build a passively managed portfolio that meets your needs.

We will flesh out some of these steps in November.

There are three keys to passive investing.  

Minimize Investment Costs

You need to ensure that your transaction and annual expenses are as low as possible.

Cost control is extremely important for investment success. And it is critical in a passive approach to investing.

We have already considered the impact of costs on performance in some detail.

For a reminder as to why minimizing expenses is crucial, please refer to my previous posts on the subject: Compound Return Investment Lessons, Minimizing Investment Transaction Costs, Mutual Fund Concerns: Transaction Costs, Mutual Fund Concerns: Operating Costs, Investment Returns Are Not All Equal.

I also include taxes as an investment cost.

It is difficult to discuss taxes in a blog with readers from around the world. But for those who do not reside in tax havens, taxes greatly impact long term investment performance.

I suggest you spend a little time understanding the investment tax laws in the jurisdictions applicable to you.

Often interest income is taxed differently than dividends. Capital gains may not be fully included in taxable income or be subject to yet a third different tax rate. In different jurisdictions, the ability to apply capital losses to past or future years may also vary.

Some jurisdictions offer tax deferred investment accounts. It is well worth one’s time to know what is available and to properly utilize such schemes to maximize compounding of current returns and to delay tax payments as long as possible.

For a general discussion on personal taxation and investing, please refer to my post, Minimizing Investment Costs: Taxes.

Match the Benchmark Return

The point of passive investing is not to try and beat the market, only to match it.

So you want to ensure that your returns match the benchmark index as closely as possible.

Not all index funds are created equally. Depending on the fund and its mechanics, actual results can vary materially from the benchmark index. Even under a passive approach.

Funds may be created using full, partial, or synthetic replication. Each method has some potential advantages and disadvantages. We will briefly review each system in my next post.

There may be tracking errors based on how well a fund can re-create the benchmark index. The greater the tracking error, the greater the deviation from the benchmark return.

As well, index funds incur costs in operating the fund. The benchmark index has no costs to reduce returns. This also negatively impacts fund performance versus the benchmark.

As a result of tracking errors and internal operating costs, the net return for an index fund may materially differ from that of the benchmark.

Make certain that you do not assume that an index fund is an index fund is an index fund. As with any investment, do your due diligence and attempt to find funds that have closely matched the benchmark over previous years.

Meet Your Personal Investment Objectives

Ensure that you choose appropriate passive investments to meet your investment objectives.

This refers to two different things.

First, what investments should you include in a passive portfolio.

For most investors, this usually means the use of low-cost index mutual funds or exchange traded funds. For a few investors, derivatives and other financial instruments may also be used to create a passive portfolio. Our focus at this time will exclude more advanced tactics.

We have discussed mutual funds previously in some depth. I will add a separate post specifically on index funds.

We have not yet reviewed exchange traded funds. We will do so shortly.

Second, this refers to how you divide up your investment capital.

Many studies conclude that one’s asset allocation is the prime factor in determining portfolio performance. So it is a very important topic.

We will look at this in detail when we cover asset allocation.

We will also cover how to determine your investment objectives and personal constraints when we look at investment policy statements.

Sometimes objectives and constraints are not as clear as one may think. Further, as one’s personal circumstances change over time, one’s objectives and constraints also change.

So that is what we will cover over the next while.

I think they are important topics and I hope they provide some value for you.

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