Passive investing has changed significantly over the past two decades, transforming the global financial market in the process. Index funds and ETFs used to be niche products, but now they are common investment options for small- and mid-sized investors.
The markets are efficient, so the investor using these services simply follows them rather than trying to beat or master them. However, this logic doesn’t work with all asset classes. When it comes to bonds and cryptocurrencies, passive investing isn’t always the simplest and most profitable option.
The difference is due to structural differences, liquidity constraints, pricing mechanisms, and volatility profiles.
In this article, we’ll go over how active and passive investments perform across all three major asset classes: stocks, bonds, and crypto. We’ll explain why indexing works for some assets, such as equities, and why it’s limited in fixed-income markets. Crypto indexing remains an experimental and imperfect solution for which traditional investment approaches may not apply. Investors will better understand their chances and risks if they understand the difference between these assets.
The Basics of Passive vs. Active Investing
What Is Passive Investing?
Passive investing refers to the approach to investing that aims to replicate the performance of a specific market index rather than outperform it. This means that the investor isn’t selecting specific individual securities; instead, they are holding all of the assets in an index. For instance, an investor can hold a small portion of all assets in the S&P 500. This is most commonly done with the help of index mutual funds or exchange-traded funds.
The appeal of the passive approach lies in its efficiency and simplicity, making it suitable for an investor who doesn’t know much about stock picking. They don’t require extensive research or frequent trading. This approach is therefore a “set it and forget it” way to investments. Since there are no brokers to pick and choose the stocks, the overall cost of trading is lower, and in the long run, that adds up.
What Is Active Investing?
Active investing is the practice of trying to outperform benchmarks by selecting assets based on research and forecasts of their future performance. It also uses market timing to buy low and sell high. Active portfolio managers adjust their portfolios all the time to respond to economic conditions, valuation changes, and perceived opportunities or risks.
This approach shows its value in less flexible markets, but it also comes with a cost that investors should be aware of. Higher fees and increased turnover should be taken into account. Poor decision-making can sometimes lead to worse performance than a passive investing approach.
Why This Debate Matters
Choosing between the two isn’t a matter of personal philosophy. The decision can directly affect how much an investor can earn and how closely they need to monitor the investment, or whether they need to hire experts to do so.
Why Indexing Works Well for Stocks
Market Efficiency and Broad Participation
Equity markets are among the most efficient markets in the world, especially so in developed countries. The investors can be counted in the millions, ranging from small-time retail investors to huge multi-billion-dollar companies. All of them make trades almost every day.
The constant flow of information is reflected in stock prices, and therefore, no investor can have an edge over others. This efficiency means that broad equity indices tend to capture most available returns. No one can consistently identify undervalued stocks and buy them before they jump in price, at least not across a wide range of industries. Over the long run, most active equity managers underperform their benchmarks over long periods after accounting for fees.
Cost Advantages and compounding
Low cost is one of the best arguments for passive investing in stocks. Even a slight difference in fees tends to compound over years of investing, especially as the amounts invested increase. Passive equity ETFs often charge expense ratios measured in basis points. On the other hand, active funds charge fees as a percentage. This is because there’s much less labor involved in trading this way, and investors don’t need to cover the costs of expert analysts and brokers who handle active trading.
The cost ranges between 0.03 percent and 0.2 percent per year, while active trading can cost up to 1.5 percent per year.
Liquidity, Transparency, and Tracking Accuracy
Stocks trade on centralized exchanges with high liquidity and transparent pricing. It makes it easy for passive funds to replicate index holdings, with minimal tracking errors. Equity indices are relatively easy to construct and maintain, especially compared to other asset classes.
Inclusion criteria are also more precise than with any other asset, and rebalance schedules are easy to predict and follow. Operations are therefore much less complex than with different assets and hence less costly.
Historical Evidence and Investor Adoption
There are decades of data covering the performance of passive stock trading. The evidence clearly shows that the performance outranks that of active trading when the long view is taken into account. It shows that even the best traders and brokers can’t keep up with an index fund designed to track the market.
This has led to massive capital inflows into the index funds. Over the years, index funds have become a dominant way to invest, driven by the benefits we mentioned and by additional peer pressure from capital inflows.
Challenges of Passive Investing in Bonds
Structural Differences in Bond Markets
Bond markets differ greatly from equity markets, so they are not as well-suited to passive investing. Instead of a limited number of continuously traded securities, the bond universe consists of millions of individual instruments. These vary in terms of maturity, credit quality, coupon structure, and issuer.
Bonds are also not traded as frequently, so there’s much less data to base predictions on. Prices are also derived from dealer quotes rather than active market transactions.
All of these complexities make it more difficult to replicate indexes. Bond indices often rely on sampling techniques, rather than full replication. There are often errors and inefficiencies in that process that investors should take into account.
Market-Cap Weighting Issues
Most bond indices weight holdings by the amount of debt outstanding. This means that the largest borrowers are the most represented. In most cases, those are governments or companies that are heavily in debt.
In the equities market, market capitalization reflects investors’ confidence in an asset. This isn’t the case with bonds, and bond market-cap weighting can unintentionally allocate more capital to the most leveraged issuers. Investors don’t make their decisions on the same principle; instead, they choose based on their risk preferences. It makes bonds less reliable to invest in.
Liquidity Constraints and Trading Costs
Liquidity can vary in bond trading, since bonds are not traded as frequently as other assets. They are often traded over the counter rather than at a centralized exchange. When passive bond funds need to rebalance to match an index or meet investor redemptions, they may need to sell the bonds at any price they can get at the moment.
Transaction costs are also increased due to wider bid-ask spreads, dealer markups, and limited market depth. Such costs aren’t always captured in the fund’s stated expense ratio, but they reduce the overall performance.
The Role of Active Bond Management
Skilled active managers play a big role in how bonds are traded, because they are not traded as efficiently as stocks. A good active manager can therefore save the investors a lot of money, and they are rewarded for their work with somewhat higher fees.
By managing duration, credit exposure, and issuer selection, active bond funds can exploit pricing inefficiencies that passive investing can’t.
The Complexity of Indexing in Crypto
What Crypto Indexing Looks Like Today
Cryptos are traded somewhat similarly to stocks, and safe and secure exchanges can be used to buy and sell crypto assets at any time, allowing investors to gather a large amount of data. This means passive investing is possible, and experts at CCN have written about many investors who already do so.
However, there are also differences between cryptos and bonds that the investors should be aware of. The crypto ecosystem lacks standardized benchmarks, and index construction methods vary widely. This means a crypto index needs to be rebalanced more often, which, in turn, increases the cost of managing it.
Volatility and Correlation Risks
Cryptocurrencies also have additional risks, stemming from the volatility of the crypto market as a whole. Cryptos often drop and rise in price in short intervals, which can be a great way to make profits fast, but it’s not always suited to long-term, passive investment. The only way to hedge against such a risk is to diversify the index by investing in as many different cryptocurrencies as possible.
A crypto index can also experience a drawdown similar to those that happen when you’re holding a single dominant asset. This occurs because the entire crypto market experiences simultaneous ups and downs, often driven by the price of Bitcoin and a few significant altcoins.
Regulatory and Structural Challenges
Crypto is now more widely used than ever before. Governments have also accepted crypto as a valid form of investment, though not as an alternative to fiat currency. This means there are more regulations, and the field is safer overall.
However, introducing more regulation reduces market certainty, as new regulatory costs are passed on to investors and holders. Custody risks, exchange reliability, and jurisdictional differences add layers of complexity that don’t occur in traditional markets.
Why Active Approaches Often Dominate Crypto
An active approach is more commonly used with crypto investments because the market is fast and volatile. The active approach allows investors to respond to rapid market changes and select altcoins that pique their interest.
A purely passive investment approach doesn’t produce consistent results, and neither does the active one, at least when the long-term view is taken into account.
Hybrid and Enhanced Indexing Approaches
Hybrid strategies are made to combine the qualities and advantages of both active and passive approaches. Enhanced indexing, also known as smart beta, modifies traditional index construction by incorporating factors such as volatility, momentum, or quality. These two approaches are used to improve on and replace the existing ones.
Another common way to do it is to use a core-satellite portfolio. Investors use passive funds as the core of their investment portfolio. Smaller portions of the portfolio are then allocated towards an active strategy of bonds, cryptos, and other assets.
Practical Takeaways for Investors
Passive investment remains the best option for equities. Broad stock indices offer diversification, low costs, and strong long-term performance. These features make them the best way to go for most investors.
Passive investment is also the best option for those with a fixed income. Those investors mostly focus on government bonds or highly liquid segments. However, there are structural limitations to these, and investors should be aware of them. Active management is sometimes a good way to hedge against such limitations.
In crypto, indexing should be viewed as experimental rather than definitive. It does provide simplicity, but there’s still the volatility inherent to crypto assets. Active strategies often provide better results for crypto.
Conclusion
Passive investing has a reputation as a reliable and simple way to invest, especially in equity markets, where liquidity, transparency, and efficiency support effective indexing. However, in more complex markets, there are limits and downsides to passive investing.
The key takeaway should be that passive investing isn’t always superior, nor is active investing. The approach needs to be balanced and based on the context of the assets you’re investing in. In crypto markets, in particular, passive investment is an evolving concept, as is the market itself.