Passive trading strategies

Passive Investing.

What is 'Passive Investing'

Passive investing is an investment strategy that aims to maximize returns over the long run by keeping the amount of buying and selling to a minimum. The idea is to avoid the fees and the drag on performance that potentially occur from frequent trading. Passive investing is not aimed at making quick gains or at getting rich with one great bet, but rather on building slow, steady wealth over time.

BREAKING DOWN 'Passive Investing'

Also known as a buy-and-hold strategy, passive investing involves buying a security with the intention of owning it for many years. Unlike active traders, passive investors are not attempting to profit from short-term price fluctuations, or otherwise "time the market." The basic assumption that underpins a passive investment strategy is that the market generally posts positive returns given enough time.

Passive Investing Strategy.

Traditionally, passive investors attempt to replicate market performance by constructing well-diversified portfolios of individual stocks, a process that can require extensive research.

With the introduction of index funds in the 1970s, achieving returns in line with the market became much easier. In the 1990s, exchange-traded funds, or ETFs, that track major indices, such as the SPDR S&P 500 ETF (SPY), simplified the process even further by allowing investors to trade index funds as though they were stocks.

Now that mutual funds and ETFs allow for index investing with relatively little initial research, the most difficult skill for passive investors to master is emotional control. Resisting the urge to sell when the market experiences a downturn requires patience and a strong stomach. When a rapid sell-off triggered circuit breakers that shut down trading in August of 2015, for example, iShares Core S&P 500 ETF (IVV) and many other ETFs tracking the S&P 500 suffered significant losses, as investors panicked at the lack of pricing information and liquidated their holdings.

Passive investors must have the presence of mind to weather these storms and trust that the market will correct itself with time.

Testing Passive Investing.

A highly vocal defendant of passive investing is value investor Warren Buffett. His approach as Chairman and CEO of Berkshire Hathaway Inc. (BRK-A, BRK-B) exemplifies some of the principles of passive management, including ultra-long investment horizons and infrequent selling. In a sense, however, he is an active investor, since he invests in companies based on particular competitive advantages.

While his style of investing cannot be considered fully passive, Buffett is a big proponent of index investing. In 2008, to prove the superiority of passive management, Buffett challenged the hedge fund industry – the quintessential active investors – to a 10-year contest. He put a million dollars in Vanguard's S&P 500 Admiral Fund (the first index fund available to retail investors), while Protégé Partners LLC, the hedge fund that took him up on his challenge, picked five fund of funds.

Though the bet is still running as of 2016, Buffett's passive strategy has proven its worth thus far. By the end of 2015, Buffett's passive bet had generated a 66% cumulative return compared to Protégé's 22%.

Active and Passive Traders.

The difference between active and passive trading is like the difference between the actions of one individual versus the actions of a group as a whole; an alternative way of thinking about active trading is like trying to bet on who will win the Super Bowl, while passive trading would be the ability to profit as all the NFL teams collectively made money on ticket and merchandise sales. Each strategy has certain advantages.

Each strategy has certain advantages. In passive investing, a lot of return can be collected after significant time if stock takes a favorable course. But for volatile stocks that are not expected to necessarily rise greatly over months or years to come, short term transactions that exemplify the active investing style can make the most of the market.

Active traders sometimes border on the fanatic. They read everything on investing, study the stocks, and subscribe to magazines, associations, or newsletters. Their motivation can be to flip stocks and make money fast, or it can be the satisfaction of finding a treasure missed by Wall Street pundits. Whether driven by wealth or ego, this type of investor turns investing into their hobby and even passion.

These investors learn how to read financial statements, market predictions, economic analysis reports, and editorials. They learn the names of the world's best economists, and are familiar with the London and New York Times Newspapers.

An active trader buys and sells stocks with the intention of making money in the short term. Active traders typically don’t hold individual stocks for many months or years, and generally do not focus upon long-term economic trends.

Also, an active trader who seeks to buy and sell the same stock shares during a single day often fits the definition of a “day trader”.

Being labeled as an active trader under the definition of “day trading” is defined by three main characteristics:

Time frame - Very short, usually within a trading day. Purpose - Active traders attempt to profit from the daily price fluctuation of a particular stock. They rely on technical analysis rather than fundamental analysis for predicting these price fluctuations. Volume - Active traders make multiple trades throughout the trading day. In addition, active traders usually scale out of positions, meaning they sell portions of their investment throughout the trading day.

Day traders have the potential to make (or lose) money quickly, but must devote much more time to trading than most long-term investors do.

Active traders prefer stocks that are rising and promise to be a forerunner for future outperformance. They have one focus, accelerating earnings, such as from a company which has tapped into a new product or innovation that promises to hit the market hard. There are many approaches to picking stocks, based on a number of factors including stock price behavior, markets, and earnings growth.

Active traders aren’t involved in trading to earn money from corporate dividends. They also do not usually purchase preferred stock, which offers benefits that are oriented toward people who invest for the long-term.

Compared to other traders, somewhat different tax rules apply to active traders. Pages D-3/4 of the Schedule D instructions provides details on these differences, as well as additional information on how to determine the definition as an investor or trader.

This type of stock trader is often interested in investing their money, but they do not want to spend their weekends studying financial statements, markets, and even weather reports. This type of investor laughs at the good luck mantras and charms used by some investors. They are often happy to put their money in the hands of a broker and walk away.

The passive trader creates a plan, researches stocks, invests, and then patiently waits for a return in the future. A passive investor takes a look at the company's value, assets, debt, and financial health. They consider market and competition when estimating the company's opportunity for success. They are not aggressive, or looking for a quick gain.

As long as their losses are not in the high-risk level, they leave their portfolio alone. They follow the 10% rule when estimating acceptable loss. Once a stock falls 10% below what they paid, it is time to sell to the bargain hunters.

Passive trading relies on the fact that over time the market has always gone up. If a trader is not passionately interested in the stock market and they’re investing mainly for retirement, a passive strategy may be the best bet.

Passive trading can deliver a decent return in the long run with a minimum of involvement. Two things are critical to this strategy:

Choosing stocks that have good potential to increase steadily in value over the term of the investment, and Selecting a diversified portfolio, to offset the unforeseen fate of one particular company or market sector. To achieve this they can consider hedging by adding instruments such as bonds, which tend to go up in value when stocks are going down.

Passive investing advantages.

The main advantage of this strategy is that, when properly employed, it can bring in a lot of profit, rather than a series of small, short-term profits garnered by the active investing approach. For instance, at a time when the auto industry has been greatly suffering, passive traders may buy a significant amount of shares of a car company that they thinks will rebound, and wait years for the industry to improve, and the company stock to increase by, say, three times. If the trader avoids short-term trades that may mean selling at small increases, more money can be made in the long term if stock steadily climbs.

Although passive traders regard short-term fluctuations in stock prices as minor compared to long-term growth, they still can't just pick a portfolio and forget about it.

Often, passive traders do not even monitor stock. One good reason for this is that checking in regularly could reveal enticing short term values that might cause traders to abandon their strategy and settle for short term gains rather than the expected, more favorable long term gains that may result from successful passive investing. However, even passive traders should re-evaluate the performance of their stocks periodically and respond to long-term market changes.

Double Your Passive Income With This Dividend Investment Strategy.

By Angel Clark, VectorVest, Inc.

Passive income. Sounds nice, doesn't it? Like you can just sit back in a sunny lounge chair while the money rolls in. That's essentially what it is - an income stream that doesn't require work. You may have even heard dividend income referred to as passive income.

I suppose it is, if you have someone managing your portfolio for you. But for those of us outside the billionaire club that may not be able to afford the best money managers and don't trust the rest, generating portfolio income - especially enough to live on - can sometimes be a mental and emotional feat worthy of an Olympic gold medal (or at least the bronze). It only makes sense that the resulting, sometimes-not-so-passive income you generate should be as profitable as possible. Here's a simple, but effective strategy you can use to get more bang for your buck: VectorVest calls it the Double Juicy strategy.

In a nutshell, it's a triple whammy - option premiums, dividends and a little capital appreciation. When aligned correctly, you'll keep the stock for long-term capital gains (more often than not), pocket the dividend check and collect nice, not-so-little bonus income from selling covered calls (often making you more money than the dividend. If you've never heard of covered calls or thought they weren't for you, go here for a quickie lesson).

It's not just buying a stock that pays dividends and randomly selling calls; this strategy is about the timing. When you do what you do. Two mistakes that beginners often make are: one, rely solely on dividends rather than incorporating option strategies and two, leaving the option open with little time value left until the ex-dividend date is declared. Either one of these mistakes can hit you right where it counts, your bottom line. Why?

If you are still short the call before the ex-dividend date, then it's often to the buyer's advantage to exercise the day before the ex-dividend date and be the owner on record to receive the dividend. (The exception would be when there's considerable time value left in the option. Time value is lost upon early exercise, so if the time value lost exceeds the dividend gained, the stock is much less likely to be called away.)

Let's take a one-year look at Johnson and Johnson (JNJ), 8/27/13-8/27/14.

In order to collect the dividend, you must own the stock by the ex-dividend date. Within the one-year period listed, we would have missed the first ex-dividend date, but we could have picked up the stock anytime afterward. Let's say we picked it up after the payout that occurred on 9/10/13, the stock closed that day at $88.53. To keep the math simple, we'll say we bought 1,000 shares (allowing us to write 10 covered calls contracts).

The next ex-dividend date was 11/22/13, by which time the stock had risen to $95.25. On this same date, the $95 December call could have been sold for $1.24 per share. (Quick explanation if you are totally new, $95 is the strike price, $1.24 per share is the premium you would pay to buy or get paid to sell, this option would expire the third Friday in December. Options are traded in contracts that consist of 100 shares, so 10 contracts would control 1,000 shares of stock. $1.24*1,000=$1,240.00 received.)

(Tip: Don't sell the calls at the open of the ex-dividend day. The price of the stock trades down at the open to compensate for the dividend being paid.)

The dividend of $0.66 per share was paid to you, the stock owner on record as of the ex-dividend date. This resulted in a dividend check for $660.00 issued 12/10/13. On this same date, the stock price had pulled back to $94.14 and the call premiums could have been purchased to close (if desired) for .41 per share, but the stock continued to pull back to $92.09 as of option expiration, allowing you to keep the full $1.24 per share premium, the stock and the dividend. By selling the covered call, you nearly tripled the cash that would have been generated by the dividends alone ($0.66 vs. $1.90 ($0.66+$1.24)).

Let's continue with our example.

JNJ's next ex-dividend date was 2/21/14, the stock was now at $91.52. The $92.50 calls, expiring in March were .88 per share. The dividend payout was once again .66 and took place on 3/11/14, stock price $93.49. Since the calls continued to go up in value and were in-the-money (lower than the stock price), the buyer could exercise their right to buy and you could be assigned, which means your stock would be sold at the agreed upon strike price of $92.50 per share. Let's break that down.

That means that in the worst case scenario our stock was sold for a higher price than when we sold the calls, we still keep $880 (.88 per share) from the option premium and because we waited until the ex-dividend date to sell, we also collect $660 in dividends. We give up the capital appreciation beyond $92.50 and we are likely to buy back into the stock at a higher price (if we wish to continue with the same stock). Not really a big deal. What can be a big deal are taxes.

If you've owned the stock less than a year, you will pay a higher tax rate. More than a year qualifies for long-term capital gains rate of 15%, versus regular income tax if the stock is held less than a year. Providing this isn't a holding that you have enormous capital gains in, the increased cash flow should compensate for higher taxes that may be incurred. Let's continue, then we'll net everything together.

We get right back into JNJ after it's called away. Let's say it's on the Monday after our March calls expire, JNJ is $95.20 on 3/24/14. The next ex-dividend date is 5/22/14, the stock is now $100.96. I have a choice, I can sell the June 100 calls for $1.83 or the July $105 calls for $0.49. If I want to give myself some room to gain from a continued up move in the stock, as well as minimize the risk of the stock getting called away again, I'll take the July 105's ($0.49x1000=$490).

The dividend payout of $.70 per share occurs 6/10/14. As of option expiration, the stock is at $101.80 on 7/18/14. Since it is below the strike price sold, we keep the full option premium, the dividend and a negligible amount of appreciation.

Let's review and compare.

We incurred approximately a 15% higher tax rate (estimating 30% total) when we sold in March. We repurchased at a higher price. This resulted in 3.8% less capital appreciation; however, our income was increased by 129%. That's pretty significant.

By selling covered calls on the ex-dividend date, we had a high success of keeping the stock, keeping the dividend and of course, we keep the covered call premium whether the stock gets called or not. Had we ignored the timing of our calls though, we could have missed out on the dividends entirely.

At first try, this might seem complicated. It's a little like watching a kid try to step on the escalator for the first time - every time they go to take a step, they think they've missed their chance, but eventually they get the timing just right and enjoy the ride. You will too, and when you do, your passive income will be all the more worthwhile.

Note: JNJ was selected due to its high rating in the VectorVest System. If you'd like to know what your stock is worth, how safe it is and whether to buy, sell or hold, you can analyze any stock free at vectorvest/AnalyzeNow.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of NASDAQ, Inc.

Passive investing is profitable, but there's a time to get active.

As index funds and exchange-traded funds continue to outpace their actively managed mutual fund peers, the church of passive investors has enjoyed an undeniable membership surge.

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Why pay for professional management, the argument goes, if they can't deliver higher returns?

"There have been massive inflows into passive funds over the last few years," said Katie Nixon, chief investment officer of Northern Trust Wealth Management. "It's been so long since active funds have outperformed passive ones that people just got sick of it.

"They threw up their hands in 2014 after several years of pretty acute underperformance, found an index fund and called it a day."

It's easy to see why.

The S&P Indices Versus Active (SPIVA) scorecard, which measures the performance of actively managed funds against their respective benchmarks, found 87 percent of large capitalization fund managers underperformed the S&P 500 Index over the last five years, and 82 percent failed to deliver incremental returns over the last decade.

Similarly, Northern Trust Wealth Management found that 84 percent of actively managed domestic mutual funds, regardless of market cap, underperformed their respective benchmarks between December 2004 and December 2014.

Proponents of passive investment strategy, a concept championed by Vanguard Group founder and former CEO Jack Bogle, maintain that low-cost index funds and exchange-traded funds, or ETFs, are the better bet for investors over the long haul, since higher fees and taxable distributions negate any real return that most active fund managers eke out.

Index funds seek to replicate a market index, such as the S&P 500 or Dow Jones Industrial Average, by owning all securities in that index. They do not pay fund managers to actively select the allocation of stocks or bonds within the fund, which translates into lower fees.

The average expense ratio for all passively managed funds—including domestic, international, sector, commodities, fixed income and alternatives—is 0.91 percent, compared with 1.23 percent for the average actively managed fund, according to Morningstar.

Sitting tight.

Index equity funds are far less pricey still, averaging roughly 0.25 percent. For its part, the Vanguard 500 Index fund charges 0.17 percent.

Passive investors, also known as buy-and-hold, do not seek to profit from short-term price fluctuations or attempt to time the market. Instead, they assemble a broadly diversified portfolio of funds across and between market sectors. Then they sit tight.

"A person who has a longer investment horizon would likely benefit more by owning only index funds and making sure they keep emotions off the table," said Herb White, a certified financial planner with Life Certain Wealth Strategies.

"Indexes, like all investments, have good days and bad days, so the investor has to be disciplined enough to stay the course when things are down."

Passive investment funds, he said, are also ideal for those who favor a hands-off approach and have neither the expertise nor inclination to educate themselves on market nuance.

Chris Cook, president of Beacon Capital Management, agrees that a passive investment strategy is appropriate for most investors but said he also sees value in monitoring the market.

Most of Cook's clients are nearing retirement or already there and lack the time horizon to wait for a market recovery. Thus, if the stock market dips by 10 percent or more, he intervenes.

"When the market drops by that amount, there's a 50 percent chance it'll drop another 10 percent," Cook said. "Half the time it's just a correction, and half the time it's a bear market, but we err on the side of safety.

"That's when we start looking really hard at fixed income," he added.

To ensure diversification for his passive portfolio, Cook relies heavily on Vanguard's collection of 11 U. S. industry sector ETFs and one international sector ETF. "We weight them equally so we don't have to worry about style drift, which keeps the portfolio pure," he said, noting the model is not designed to chase returns in a bull market; it's designed for stability.

Despite their dismal track record of late, mutual funds managed by a market professional may still have a place in the average investor's portfolio, said Nixon at Northern Trust Wealth Management.

Indeed, many investors have a bit of both.

Index or more active?

"We're not prescriptive in terms of mandating that clients embrace either strategy," she said. "We recognize the benefits and drawbacks of the different approaches and let our clients' needs determine which approach we use."

Clients whose financial goals are fully met by achieving the market return, less a minimal expense fee, are advised to stick with index funds, while those who need (or wish) to generate more might be advised to select more active funds, said Nixon.

"For many investors, risk is a requirement because they have a required return to meet their goals, which might be lifestyle post-retirement, their child's education or the desire to buy a second home in eight years," she said. "If your assets based on our conservative assumptions about what the markets are going to give you over the next five to 10 years aren't enough to allow you to meet those goals, you're going to need to take more risk."

But not just any actively managed fund will do.

Because the vast majority of fund managers fail to beat their benchmark, Nixon said it's necessary to differentiate between those who generate true alpha (that portion of return above and beyond what the market delivers) and those who merely assume greater risk.

"If you're going to pursue active funds, you need a rigorous tool set to tease out true alpha," she said. "A lot of times what looks like alpha is really the manager taking more risk than their benchmark.

"I don't need to pay those expense ratios to get more risk into my portfolio."

In the active manager selection process, Nixon also screens for track record, noting past performance is no guarantee of future returns.

"Everyone has a hot hand now and then, so you need to determine whether it's random or persistent, and what we find in a very small subset of managers is that there can be true alpha that survives after fees," she said.

The new Morningstar Active/Passive Barometer, which measures the relative performance of active U. S. fund managers against passive U. S. funds within their respective Morningstar categories, can help.

According to Nixon, the managers who consistently beat the market tend to deviate from their benchmark, using data, expertise and bravado. "A lot of active managers are closet benchmarkers," she said. "They hug their benchmark, and you really want to avoid them."

She added, "We want managers who have unique investment processes, and they are very hard to find."

The third way.

Somewhere between active and passive mutual funds, said Nixon, lies a third investment strategy that may appeal to investors who need more from the market than an index fund can generate but aren't willing to pay for traditional active management.

Engineered beta, or enhanced indexing, starts with an index fund but adds exposure to certain asset classes that tend to reward investors over the long run.

Historically, for example, small companies outperform large capitalization stocks, while value outperforms growth.

Thus, if you take a domestic large-cap index fund and tilt it toward smaller stocks and value, your expected rate of return will be slightly higher with similarly low fees—although not quite as low as a traditional index fund.

"That's not alpha," said Nixon. "It's enhanced indexing. Based on the history of the financial markets, that's a high confidence bet for investors who need more than just the index return."

Investors who pad their portfolios with a combination of active and passive funds can boost their return further by focusing on asset location and tax efficiency, said White at Life Certain Wealth Strategies.

Actively managed funds, for example, which distribute more short-term capital gains (a major drag on returns) should be held inside your individual retirement account, 401(k) plan or other tax-sheltered account, while passive funds are best parked in your non-retirement account.

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In the ongoing debate over active vs. passive strategy, one thing is clear: There's no one right answer for everyone.

Those willing to pay fund managers for their stock-picking expertise, however, should select their investments carefully, know the tax profile and be sure they're delivering true alpha.

"We are coming off a period of very robust five-year returns, but the next five years are not going to look like the last," said Nixon, adding, "When capital returns are lower, these decisions can have a meaningful impact on portfolios.

"We can't control inflation or market performance, but we can control taxes and fees."