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Passive investing – what is it, and how does it work?

We take a look at where it all started for passive investing and why index funds have become more popular with investors.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Alexander Watkins
Passive Investment Analyst

Published on 8 February 2023

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

Passive investing is one of the simplest and easiest ways to invest in the stock market.

Index (tracker) funds have been around for over 45 years and are offered by a range of investment companies. But where did passive investing first begin and how does it work?

This article isn't personal advice. If you're not sure if an investment is right for you, ask for financial advice.

How passive investing works

Passive, also known as index or tracker, funds aim to track the performance of a particular index, or stock market. For example, the FTSE 100, which is made up of the UK's largest 100 companies.

This approach is different from actively-managed funds where professional fund managers invest into a select number of companies, with the aim to beat the performance of an index.

Most index funds typically invest in every stock that makes up the index it's trying to replicate – known as full replication. Some funds won't invest in every stock, but they'll hold a sample of shares which represent the wider index. This is known as partial replication.

Either way, buying and selling companies involves costs which can eat away at performance. To keep the fund's performance as close to the index as possible, index funds use techniques like reinvesting dividends at an appropriate time to keep costs to a minimum.

For example, the Legal & General UK 100 Index fund on our Wealth Shortlist tracks the FTSE 100. The fund buys every stock in the index, keeping performance in line with the benchmark. By fully replicating the index, the difference between the fund and benchmark has been 4.92%* over 10 years.

A glance at the five-year performance table below shows in some years the fund has tracked the index closer than others. We'd expect it to fall behind its benchmark over the long term because of the costs involved with running the fund.

	Jan 18 - Jan 19	Jan 19 - Jan 20	Jan 20 - Jan 21	Jan 21 - Jan 22	Jan 22 - Jan 23
Legal & General UK 100 Index	-3.62%	9.31%	-9.10%	19.47%	7.12%
FTSE 100	-3.53%	9.41%	-9.20%	20.72%	8.04%

Past performance isn't a guide to future returns. Source: *Lipper IM, to 31/01/23.

More about the Legal & General UK 100 Index Fund including charges

Legal & General UK 100 Index Fund Key Investor Information

Investing in funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a diversified portfolio.

How it started

Passive investing was made available for retail investors in 1976 when Jack Bogle, founder of Vanguard, created the world's first retail index fund. Appropriately named the ‘First Index Investment Trust’, it tracked the S&P 500 – an index of the 500 largest companies in the US.

Bogle's motto, “Don't look for the needle in the haystack. Just buy the haystack”, neatly sums up passive investments. It suggests that simply tracking an index, rather than attempting to beat it, protects investors from active managers' human error.

As with all new ideas, it was met with challenge at first. The investment space was ruled by active managers and, unsurprisingly, they weren't keen on an approach that was cheaper (and in some cases better) than their stock picking.

Over time the benefits of passive investing came to fruition, leading to the industry we see today.

As with all investments, passive funds go up and down in value so investors can get back less than they originally invest.

Index funds vs ETFs – what do you need to know?

A growing industry

Since 1976, passive investing's popularity has risen. Index funds now account for around 21% of assets in Europe and 45% in the US. The growth's been dominated by several global players, including BlackRock, Vanguard and State Street. As of October 2022, both BlackRock and Vanguard run over $7 trillion of assets globally.

In the UK there's also groups like Legal & General, which we believe offers some of the best simple and low-cost index funds in the market.

What does this mean for investors?

Bogle's venture kickstarted the passive industry, and it shows little sign of slowing. Markets across the globe can now be easily accessed using an index fund. As passive companies continue to develop, they benefit from their scale, driving down costs. This helps investors track their favourite indices at lower costs.

BlackRock and Vanguard continue to lead the charge, amassing more money over time. This trend only seems to grow, but can it persist? We'll have to wait and see.

An index fund is one of the simplest ways to invest, and we think these funds could be a great, low-cost starting point for a portfolio aiming to deliver long-term growth. They could help diversify a portfolio focusing on active managers (ones that try to beat the market) or individual shares and bonds.

For investors interested in index funds, take a look at our Wealth Shortlist of funds selected by our analysts for their long-term performance potential.

The Wealth Shortlist includes funds across a range of sectors, and risk levels that won't be right for everyone – it isn't personal advice.

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Our fund research is for investors who understand the risks of investing and that investing in funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a diversified portfolio.