Enterprise Explains: Passive investing. Passive investing has exploded in popularity in recent years as more retail traders pile into the market in search of easy gains. Worldwide inflows into exchange-traded funds (ETFs) — one of the most common passive investment tools — reached a record USD 1.22 tn last year, pushing global ETF assets to nearly USD 9.5 tn, which is more than double where the industry stood just three years ago.

But what’s passive investing, you ask? A passive fund is an investment vehicle that tracks the value of an asset. Index funds follow the ebbs and flows of a specific stock index, and are one of most popular approaches to passive investing. They work by purchasing shares in all of its companies in a given index, say the S&P 500 or the Dow Jones. Doing this means that when the value of the index rises and falls, the value of the fund follows it. Unlike with an active fund, passive funds don’t require a manager to pick and choose securities and do the research. This means lower fees, making them a whole lot cheaper to invest in.

It sounds simple, but there’s more to it: Passive investing is really a long game. When you own small pieces of thousands of stocks, you earn your returns by cashing in on the upward trajectory of companies’ gains over time, and this might require patience — and sticking through some setbacks and downturns. Passive investing isn’t limited to stocks, either: you can passively invest in commodities, bonds and currencies via ETFs.

The difference between ETFs and index funds: While both are commonly used passive investment tools, there are some key differences between both. The biggest one is that index funds are traded once at the close of each trading day, whereas ETFs can be traded at any point throughout the day, offering a degree of flexibility — and liquidity — for investors. With ETFs, an investor has to rely on someone buying their shares when they decide to sell, whereas with index funds, you’re guaranteed a sale at the end of each trading day — though you have less control over the share price you’re selling at.

There are downsides to passive investing during times of economic turmoil: Given tracker funds passively track an entire index, there’s no room for hedging by buying different stocks when financial markets go sideways. If the market falls, you fall with it. If you’re in it for the long haul, you may overlook these slumps for longer-term returns, but for someone looking for easy, fast gains, they might choose to run for the hills before bearing any more losses.

Still, history is on passive investment’s side: Historically, passive investments have earned higher returns than active investments (at least, in the long term). Over a 20-year period, about 90% of index funds tracking companies of all sizes outperformed their active counterparts, according to a 2020 S&P Indices Versus Active (SPIVA) report. Even over a three-year period, more than half of index funds outperformed active ones.