This is an investment strategy where you are just tracking the market index. Investors can invest in an index fund or an ETF where the portfolio replicates the securities of a particular index. It is a buy and hold approach where investors do not need to pick individual stocks but just a fund or ETF which performs like the index. The composition of these ETFS or index funds only changes when there is a change in the market index.
The passive portfolio management is built on the principle that markets are efficient so stock prices reflect the company’s intrinsic value. This strategy does not believe stocks are mispriced.
Low fees: there are not many transactions involved as it is a buy and hold strategy
Tax efficiency: an index fund creates less capital gains tax as there is less turnover of holdings. Active managed funds have turnover ratios of 20% or more whereas indexed funds only have a turnover of 1% or 2%. When the fund manager sells the stocks at a higher price as when they brought it, they will need to pay capital gains tax, hence frequent turnover can mean more capital gains tax.
Instant diversification: Index investing achieves instant diversification as the ETF or fund is tracking the market.
Limited Upside: there is limited upside to this strategy as it merely tracks an index less the fees and doesn’t beat it
Risk Management: there is limited risk management as positions are not sold if there is market downfall or a structural change in the macro environment, they are only sold if there is a change in the market index.
Cannot be tailored to individual goals: as these funds merely mirror the market, investors cannot pick individual stocks to cater to their goals.
Lauren Hua is a private client adviser at Fairmont Equities.
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