What is passive investing?

Passive investing is an investing strategy commonly associated with long-term investing goals. Instead of attempting to predict changes in the market, determine winning stocks, or sell investments frequently, passive investors in Canada may focus on crafting a diversified portfolio and staying invested over time.

Passive investing is also associated with index funds and exchange-traded funds (ETFs) that monitor market benchmarks. Therefore, rather than trying to outperform the market, a typical goal is to earn returns similar to the market over time, without over-complicating investment decisions. This contrasts with active investing, where portfolio managers or investors seek to outperform market benchmarks.

For investors in Canada, passive investing can be used across various account types, including RRSPs, TFSAs, FHSAs, RESPs, and other non-registered investment accounts. While this investment strategy can streamline portfolio management, it does not guarantee returns. Similar to all investments, it involves risk and requires knowledge about financial goals, risk tolerance, and time horizons.

Quick answer

Passive investing is an investment strategy that involves focusing on long-term growth that builds wealth gradually through a diversified portfolio that often includes index funds and ETFs, while limiting frequent trading.

How passive investing works

In its most basic sense, passive investment strategies involve consistency over time, rather than predicting markets. Instead of reacting to short-term price changes, passive investors often choose a diverse portfolio that's reflective of their financial goals and risk tolerance. Over time, they'll continue to make contributions to their investments and commit to periodic rebalancing of their portfolios.

The process of passive investing may look something like the following:

1. Establishing a long-term investment objective.

2. Choosing a mix of diversified investments, including ETFs, index funds, and more.

3. Making regular contributions.

4. Reviewing the investment portfolio often.

5. Making adjustments to the portfolio when needed.

One thing to keep in mind is that passive investing does not mean that no attention is made to an investment portfolio after assets are purchased. Even a passive investing approach requires ongoing effort.

For example, contribution amounts and schedules may need updating, investor risk tolerance may change, and financial goals may shift. 

Passive investing vs. active investing

Active and passive investing are two different investment approaches used by Canadian investors. Below is a comparison table between the two:

Active investing may appeal to those who prefer a more hands-on investment approach. In contrast, passive investing may appeal to those who are at the beginning of their investment journey, who seek a more predictable investment approach with lower ongoing costs. The choice often depends on goals, risk tolerance, time horizons, and the level of involvement preferred.

Index investing vs. passive investing strategies

Index investing is a common form of passive investing. It involves investing in index funds that track certain market indexes, such as the Canadian equity index, or the global bond index. The purpose of these funds is to mirror market performance rather than choosing individual securities.

Index investing is often done through mutual funds or exchange-traded funds (ETFs). But not all passive investing is considered index investing, and not all ETFs are passive. Some ETFs can be actively managed funds, which is why beginning investors in Canada may seek to confirm whether the individual funds they invest in follow an active approach or index.

Passive investing in Canada

Passive investing in Canada can be done through numerous registered and non-registered accounts:

• Tax-free savings account (TFSA): TFSAs are often used for flexible, tax-free investment growth. Contribution room is determined by the CRA.

• Registered retirement savings plan (RRSP): Often used for retirement savings. Contributions are tax-deductible, with taxes deferred until withdrawal.

• First home savings account (FHSA): Specifically designed for first-time home buyers.

• Registered education savings plan (RESP): Used to save for education expenses. Contributions can be eligible to receive government grants depending on eligibility.

Many investors in Canada invest in Canadian-listed ETFs, which trade funds on Canadian exchanges in Canadian dollars. These funds may provide exposure to Canadian markets, but also U.S. and global markets as well. A key factor in comparing ETFs is management expense ratios (MERs), which are the ongoing cost of owning specific index funds. Remember, even small differences in MERs may matter over long periods of time, which is why fees are often reviewed when choosing passive funds.

Further, when investing in non-registered accounts, taxes are another consideration. Investment income, such as dividends, interest, and capital gains, may be taxable.

Potential benefits of passive management

Passive investing is often associated with simplicity and long-term consistency, offering numerous potential benefits:

Lower fees

A common feature of passive investing is lower fees. Passive funds don't often rely on active decision-making or frequent trading, which may result in lower management costs compared to actively managed funds.

Diversification

Many passive funds contain a wide range of securities across different sectors, regions, and asset classes, which can help contribute to portfolio diversification.

Simplicity

Once a portfolio is created, it often follows a simple investment structure that requires fewer ongoing decisions. With automation, regular contributions can be scheduled to maintain consistency over time.

Potential risks and limitations of passive strategies

Passive investing doesn't come without risks:

Market risk

If the market fluctuates and declines, investments tracking that market will also decline in value.

No guaranteed returns

Performance of investments depends on the underlying market being tracked and does not guarantee returns.

Tracking errors

Some index funds may experience tracking errors, where they do not perfectly match the performance of their benchmark.

Concentration risk

Some index funds may be more concentrated in a single sector or company, which could affect portfolio exposure.

Passive Investing: What to Weigh Before Choosing it

Passive investing is often used by investors who prefer long-term investment approaches.

Those who choose passive investing may have/prefer:

• Long-term financial goals

• Portfolio diversification

• Lower fees

• Straightforward portfolio management

• A reduced need for frequent trades

• Comfortable with changes in the market

Passive investing strategies may be less suited if:

• The investor requires short-term cash

• Hands-on management is preferred

• Market volatility is difficult to tolerate

How to start passive investing in Canada

To begin passive investing in Canada, many investors will:

1. Define your goal: Choose a financial goal, such as retirement savings or future education funding.

2. Choose the right account type: Select the right account type based on your financial goal.

3. Understand risk tolerance: Determine risk tolerance before selecting funds, as each carries a different level of volatility.

4. Compare funds or portfolio options: Compare index holdings, objectives, fees, and risk profiles.

5. Decide management approach: Decide whether to invest using a robo-advisor, work with an advisor, or self-managed funds.

6. Set up regular contributions: Choose a contribution schedule to build wealth gradually and consistently over time.

7. Review periodically: Review portfolio performance periodically, making changes as needed.

Common passive investing mistakes

Common mistakes first-time investors may experience include:

• Assuming passive investing is risk-free: All investment strategies are exposed to risk.

• Choosing funds based only on past returns: Past and recent returns do not guarantee future results.

• Ignoring fees: Fees can add up over time and impact long-term returns.

• Buying overlapping funds: Owning multiple funds with similar holdings may reduce diversification.

• Selling during downturns: Reacting to short-term price declines may impact long-term investment approach.

• Confusing all ETFs with passive index ETFs: Remember, some ETFs are actively managed.

• Investing without a clear goal: Portfolios without a clear goal can be muddled and misaligned.

• Ignoring risk tolerance: Even a diversified portfolio may not be aligned if risk level is too high or low for investor risk tolerance.

Conclusion: Key takeaways

Passive investing is a long-term investment strategy focused on tracking market performance through diversified investments, often using ETFs or index funds. While this approach is often associated with lower costs, diversification, and reduced trading behaviours, it still involves risks that should be taken into account.