8 Risks That Come With Passive Investing Strategies

Passive investment strategies are popular but present several risks.

In the active vs. passive investing debate, cost and performance can influence portfolio decision-making. "Passive funds generally charge lower fees than actively managed funds," says Phil Cooper, founder and CEO of Kingdom Purposes Investment Planning in Morton, Illinois. "However, an actively managed portfolio can boost an investor's returns." Where passive investing takes the lead is in enhanced transparency and tax efficiency. But it's not a risk-free approach to the market. These are the eight biggest risks to watch out for when following a passive management strategy.

Portfolio disconnection

Tiffany Welka, vice president of VFG Associates in Livonia, Michigan, says a common risk factor of passive investing is assuming that a portfolio can manage itself. "Even though investors are utilizing this strategy, the potential for gains and losses still needs to be assessed," she says. "You may not need to change your investments as frequently as other strategies, but the need for reallocation during economic or life changes is still crucial to getting the most bang out of your buck."

Chasing returns

It's important to remember that passive investing is subject to total market risk when setting expectations for returns. That includes stock market risk, longevity risk, purpose risk, inflation, interest rate hikes and taxation. Cooper says problems can arise when investors take on too much risk searching for a high rate of return in a short amount of time without an exit plan. "We never know where the highs and lows of the market are going to be," he says. "You should always go into any investment with an exit strategy in mind."

Mistiming allocations

Forgetting to account for timing can result in over- or underexposure to the market. "Passive investing may not be meant for someone close to retirement as time may not be on their side," says Brad Ewerth, owner of P23 Financial in Lincoln, Nebraska. The five- to 10-year run-up to retirement, for instance, may dictate a shift away from equity investments to mitigate risk. Younger investors, meanwhile, may want to lean into equities in a passive portfolio to capitalize on the longer window for managing volatility that's open to them.

Failing to adjust for taxes

Passive funds tend to be more tax efficient than active funds, chiefly due to their lower turnover rate. But it's risky to assume that all passive investment strategies are tax advantaged, Ewerth says. "Tax issues are contingent on the types of investments held," he says. "Mutual funds may produce large capital gain dividends without the investor actually selling anything." While investments may be passive, investors may need to be proactive in managing tax liability. Minimizing tax risk may be as simple as the oft-repeated piece of expert advice: Know what you own.

Investing emotionally

Emotions can wreak havoc in a portfolio, even one that's largely passive. "Just because an investor owns passive funds does not mean he or she won't make emotional mistakes around buying and selling at the wrong time," says Matt Topley, chief investment officer a Fortis Wealth in King of Prussia, Pennsylvania. He says behavior is one of the biggest risks, particularly since passive investments at the current volume have yet to be tested by a recession. "If everyone heads to the exits in a panic, the volatility will just happen faster through exchange-traded funds and index funds."

Mistaking active investments for passive ones

In some cases, what looks like a passive fund may be an active fund in disguise, says Vijay Vaidyanathan, CEO of Optimal Asset Management, citing active ETFs as an example. "It does not solve problems for anyone because it's just active indexing in the guise, or wrapper of an ETF," he says. Active ETFs operate like other ETFs, in that these types of funds are similar to mutual funds except these assets trade like stocks. The difference is that these funds have a portfolio manager who can adjust the underlying assets, rather than following a benchmark or index. The risks are decreased transparency with increased costs.

Equating low cost with low risk

Andrew Holpe, co-founder and managing member at Richmond Quantitative Advisors in Richmond, Virginia, says confusing the cost-efficiency of passive investing with risk reduction is wrong thinking. "Put simply, passive and cheap does not equate to less risky." Holpe says the idea that passive automatically means low risk has been exaggerated by the market's performance over the last five to 10 years. That may create a false sense of security. Investors may be more exposed to increases in market volatility than they think, as their passive portfolio does not contain active risk management, he says.

Ignoring global diversification

When U.S. equities are dominant in a passive portfolio, investors may be unconsciously costing themselves opportunities to diversify. This can be problematic for older investors nearing retirement. "The concept of sequence risk becomes a major risk factor to be aware of," Holpe says. "Even if you know what the 20- or 30-year forward return will be on your passive portfolio, you do not know the path that it will take to get there." That's what sequence risk involves, and it's important to understand when making the transition to drawing on investment income in retirement. Holpe says creating a globally diversified portfolio can help manage that risk.

Eight biggest risks that come with passive investing:

-- Portfolio disconnection

-- Chasing returns

-- Mistiming allocations

-- Failing to adjust for taxes

-- Investing emotionally

-- Mistaking active investments for passive ones

-- Equating low cost with low risk

-- Ignoring global diversification