Passive Investment through ETFs
💡Take away
- Instead of picking individual stocks, passive investing aims to reflect the entire market in your portfolio.
- ETFs offer a cost-effective way to invest in multiple stocks at once.
- Passive investing generally has a higher success rate than active investing.
- The process is fully automated, saving you time and money.
- Passive investments, like ETFs, are rational and follow clear rules, unlike actively managed funds, which are influenced by emotions.
In passive investing, you focus on the market as a whole instead of individual stocks, allowing you to benefit from overall market returns. This strategy is often more profitable in the long term than active strategies, and it also saves you time.
Active vs. Passive Investing
In active investing, investors
- monitor the market and decides which stocks are undervalued or overvalued
- Invest in these stocks with the expectation that the stock price will eventually adjust to their predicted value, allowing them to profit when they sell the stock. The active selection of stocks is called stock picking.
- Can also invest in actively managed funds, where a fund manager decides which companies to invest the investors’ money in.
- aim to outperform the market return
On the other hand, passive investors believe that it is not possible to beat the market. Instead, they invest in an average global portfolio and, in return, achieve the average market return.
Market Return: the profit generated by an investment over a specific period.
For example, if you buy a stock for €100 and sell it for €105 after one year, your return is €5. Market return refers to the profit generated by the entire market. It can be measured using an index.
Comparison:
| Active Investing | Passive Investing with a Global Portfolio | |
|---|---|---|
| Goal | “Beat” the market return | Achieve the market return |
| Source of Return | Risk and skillful strategy (cleverness) | Systematic market participation |
| View of the Market | Market as an opponent | Market as an ally |
| What does the investor bet on? | Individual companies, sectors, or time periods. Portfolio composition is frequently changed. | The global economy. No short-term shifts. |
| Degree of Diversification | Low in the classic active approach | Global, systematic diversification across asset classes |
| Investment Horizon | Individual; often not predetermined | Long-term |
| Complexity | Tendentially high: Requires understanding of the stock market and individual companies. | Low |
| Costs | Tendentially high: Frequent trading incurs order fees, trading platform fees, and other charges. | Low: ETFs with low TER (Total Expense Ratio) have minimal impact on returns. |
| Time Commitment for the Investor | Relatively high | Low |
Who Achieves Higher Returns?
A study by S&P Dow Jones, an index provider, analyzed the performance of actively managed funds over a 10-year period. The results showed that 98% of global equity fund managers underperformed their benchmark index. Among actively managed funds investing in the German market, 80% also underperformed their respective index.
Over multiple years, the likelihood of an actively managed fund outperforming the market return decreases further. Even if a fund manager achieves higher returns in one year, it does not guarantee similar performance in the following year.
Funds
A fund is a pool of capital. In the case of an investment fund, the contributed money is invested in various assets. Funds can be actively managed by a fund manager or passively regulated by tracking an index.
Why Passive Investing?
The foundation of passive investing is the Efficient Market Hypothesis, developed by economist Eugene Fama:
In an efficient capital market, all available information is already reflected in the price of a security—and our market is considered such an efficient market.
This means that all key figures, circumstances, background information, and forecasts are automatically incorporated into the price of a stock. Taking this further, we can trust that an exact replication of the market would be equally efficient. Combining this idea with the assumption that capital markets will grow over the long term, the logical conclusion is to invest in an exact copy of the market.
In short, you take existing markets and trust that the global economy, specific regions, or industries will develop positively.
Buy-and-Hold Instead of Speculation
Buy-and-Hold means buying shares and holding onto them. This strategy can be applied to various products, including individual stocks.
As a passive investor, you
- have a long-term investment horizon, meaning you hold your investments for as many years as possible
- ride out short-term price fluctuations, avoid chasing trends, and don’t get tempted by so-called “hot tips”
- only check your portfolio occasionally, as the goal is not to access the money immediately but to let it work for you over the long term
- avoid speculation, meaning you don’t rely on personal knowledge or gut feelings to beat the market.
Advantages of long-term passive buy-and-hold strategy
- Good long-term return
- Maximal diversification
- Cost-effective (ETFs typically have lower fees than actively managed funds.)
- Time-saving
- Start with small amount of capital
- No timing necessary
Tax Advantages of Buy-and-Hold in Passive Investments
Passive investing offers a tax benefit known as tax deferral, which creates a present value advantage: A significant portion of your tax payment is deferred. 👏
Over time, the effective tax rate decreases. By paying taxes later, you can let your money work for you longer.
You only pay capital gains tax when you realize your profits. If your investments remain invested and you don’t withdraw them, no taxes are due. During this time, (according German tax law) the 25% capital gains tax plus solidarity surcharge and, if applicable, church tax continue to work in your favor.
Accumulating ETFs automatically reinvest your returns. While a preliminary tax (Vorabpauschale) is levied, it is usually very low. For all ETFs, you must pay taxes on gains when you sell shares at a profit. With a Buy-and-Hold strategy, this often happens only years or even decades after the initial investment.
In Germany, every saver is entitled to a tax-free allowance (Sparerpauschbetrag) of €1,000 (€2,000 for married couples). Capital gains, such as dividends or realized capital gains, remain tax-free up to this annual limit.
How Can You Invest in the Entire Market?
To avoid the need to analyze the entire global economy and purchase countless individual stocks, there are financial products that replicate the entire world economy. These products achieve this through indices, which form the basis of an ETF’s portfolio.
3 Tips for Successful Passive Investing
Understand the Risks and Assess Yourself Accurately.
Even though the risks of passive investing are lower than active trading, you should still familiarize yourself with market risk and determine your personal risk tolerance.
Choose ETFs That Align with Your Strategy.
You can invest in different markets, regions, and currencies—depending on what matters most to you. Additionally, you can focus on specific areas, such as factor investing or ESG (Environmental, Social, Governance) criteria. You remain flexible because you can trade during regular market hours if you want to rebalance your portfolio.
Separate Passive and Active Investments
If you want to invest part of your wealth passively and use the rest for active investments or speculation, that’s perfectly fine. For psychological reasons, we recommend opening a separate brokerage account for this purpose. This way, you won’t be tempted to deviate from your Buy-and-Hold strategy with your passive investments.