Why a leveraged tracker might be the best investment of all.

If you’re a believer in passive investing, we’ve got just the thing:

Passive Investing

If you can't beat 'em, join 'em.

That, in a nutshell, is the mantra of passive investing. This popular investment strategy doesn't try to outperform or "time" the stock market with a constant stream of trades, as other strategies do. Instead, passive investing believes the secret to boosting returns is by doing as little buying and selling as possible.

What is passive investing?

Passive investing, also known as passive management, is a thoughtful, time-honoured philosophy that holds that while the stock market does experience drops and bumps, it inevitably rises over the long haul.

So, rather than try to outsmart it, the best course is to mirror the market in your portfolio, then sit back and enjoy the ride.

Simple to understand and easy to execute, passive investing has become the go-to approach for many investors. Here's how to join them.

The essence of passive investing is a buy-and-hold strategy, a long-term approach in which investors don't trade much. Instead, they purchase and then hang onto a diversified portfolio of assets — usually based on a broad, market-weighted index, like the S&P 500 or the Dow Jones Industrial Average. The goal is to replicate the financial index performance overall — to match, not beat, the market.  

Perhaps the most common passive investing approach is to buy an index fund tied to the market. These sorts of funds are often known as passively managed, or passive, funds. The underlying holdings in passive funds can be stocks, bonds, or other assets — whatever makes up the index being tracked.

If the index replaces some of the companies included in it, then the index fund automatically adjusts its holdings, selling the old stocks and purchasing the new ones. Thus, investors profit by staying the course and benefiting from the market increases that happen over time.

A brief history of passive investing

Though buying and holding onto stocks is nothing new, passive investing as an official strategy first emerged in the 1970s with the creation of the first index fund for individual investors.

It was a new type of mutual fund, pioneered in 1976 by John C. Bogle, the then-CEO of investment company The Vanguard Group. Named the Vanguard 500 Index, it allowed thousands of regular investors to buy shares in a fund that mirrored the S&P 500 — the 500 largest companies in the US. Priced cheaper than many mutual funds at the time, it enabled "the little guy" to have a stake in some of the market's best companies, without the cost of buying them individually, and without much effort.

Other companies followed suit in offering index mutual funds. Then, in the 1990s came another innovation: exchange-traded funds (ETFs). They, too, were designed to track various indexes — and with even lower management fees than mutual funds. And also greater liquidity, since ETFs trade throughout the day on exchanges, like stocks themselves.

Cheap, diversified, and low-risk, they were tailor-made for a buy-and-hold strategy — and vice-versa. It was the advent of ETFs that really made passive investing part of the financial conversation, especially for retail investors.

Key features of passive investing

The ultimate goal of passive investing is to build wealth gradually, as opposed to making a quick killing. With the application of compounded returns, an investment of £50,000 into an S&P 500 index tracker 25 years ago, would today be worth £642,983.

The index has returned a historic annualized average return of around 10.26% since its 1957 inception through the end of 2023.

Index trackers are on the rise. Warren Buffett famously said, ‘By periodically investing in an index fund the know-nothing investor can actually outperform most investment professionals’ and investors have taken note.

The core principle underlying passive investing strategies is that investors can count on the stock market going up over time. By mirroring the market, a portfolio will appreciate along with it. The equity market will encounter many bumps on its road to growth, but it has always overcome them in the past.

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Recent drawdowns for the S&P 500 (a drawdown is the % amount lost from peak to trough)

Passive trackers tend to be cheaper than active as they require less input from the fund manager. They are also diversified as they hold the entire index, rather than just a few shares within it, which tends to therefore make them less risky than individual stock-picking funds.

The index has always recovered in the past, whereas individual stocks have not. Investing in the whole index negates the repercussions of a company going under while you’re invested.

There are however downsides.

Downsides to passive investing

While passive investing has a great many benefits, it has its drawbacks too.

• Live by the benchmark, die by the benchmark. Index funds follow their benchmark index regardless of the state of the markets. Translation: They'll rise when the index is performing well, and they'll also drop when prices decline. And if the whole market goes into freefall…
• Lack of flexibility. Even if index fund managers foresee a decrease in their benchmark's performance, they typically can't take such steps as cutting back on the number of shares they own, or take a defensive, counterbalancing position in other securities.
• Fewer windfalls. Since passive funds are designed to mirror the market, investors are unlikely to experience the big coups that actively managed funds can sometimes provide. In other words: No catching that rising stock star. Even if a fund did, it might not benefit as much, since the returns would be mitigated by the other holdings in the portfolio.
• Less pain but less gain. Buying and holding can be a winning tactic in the long run (at least a decade or two). You weather the market volatility. But evening out the risks also flattens out the rewards. In shorter time spans, active investing often provides better results and juicier gains.

So, we can see that passive investing works. Over time, the index will rise in value. It goes without saying that the value of your investment can go down as well as up and that past performance is no guarantee of future results, but we can make decisions based on empirical evidence.

We can also see that there will be drawdowns, periods where the market performs badly. The crash in 2022 on the back of high inflation and high interest rates; Covid in 2020 etc. They will happen, but they have always also passed.

At TPP what we have done is take the concept of passive investing, but sought to conquer its negatives.

If passive investing works, and we know that it does, then why track the benchmark at 1:1? At TPP we use financial derivatives to track global indices at a multiple. Our S&P 500 tracker moves with the market at a rate of around 1.5:1. This may not seem like a lot more, but let’s revisit the £50,000 investment made 25 years ago. Rather than having £642,983, you would instead have a portfolio worth £2,287,145.

The negative moves are also heightened, but as we’ve seen, as long as the market comes back, the long-term investment objective remains intact. The reason we use leverage of 1.5:1 is so that large drawdowns can be tolerated. If the market falls 34% as it did in 2020 during Covid, then the tracker will fall 51%. However, if the tracker continues to track, this fall is temporary and new highs will eventually be reached.

This is our answer to the ‘less pain less gain’ issue above. It increases the temporary pain but also increases the long-term gain. A fund manager may occasionally be able to outperform the index, but by 50%? This is incredibly unlikely.

To counter the other issues such as ‘live by the benchmark, die by the benchmark’ and its inflexibility, we use another financial derivatives. By placing ‘options’ within the tracker structure we negate black swan events.

The biggest fear of a tracker is a large fall in the market. Without going into too much detail we are able to limit this loss. If the tracker falls below a predetermined level, usually around 10%, over a quarter then it ceases losing money.

Our professional traders have developed a structured product designed to take the best of passive investing, while taking out its greatest flaws.

If you’re looking to build a portfolio that is linked closely to the markets but outperforms it each and every year (when markets are positive) contact our team for a FREE consultation call.

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