Passive Alternative Investments Versus Stock Market Investing
The term “passive investing” has become increasingly prevalent with the rise of index funds and ETFs over the last decade. While most investors understand its basic premise, many are unaware of the important ways in which passive investing can benefit them, and of the opportunities available to those seeking exposure to alternative asset classes.
What Is Passive Investing?
Passive investing broadly refers to the act of making investments that require little (if any) additional investment of energy and effort on the part of the investor. To put it more formally, it is an investment strategy that aims to maximize returns over a long-term investment horizon by minimizing buying and selling. Passive investors focus on limiting their own involvement in the investment process without sacrificing return. Rather than engage in frequent trading in pursuit of short-term profits, passive investors adopt a “buy-and-hold” mentality that emphasizes the build-up of profits from a single investment over time.
How Does This Differ From Active Investing?
As the name implies, active investing is a more hands-on approach that places much greater responsibility on the investor for investment performance. Rather than aim to replicate market returns with a diversified portfolio of stocks or other assets, active investors attempt to outperform markets by taking advantage of short-term inefficiencies, trading frequently to profit from perceived price discrepancies.
The Passive Advantage
The primary advantage of passive investing is that it is cost-efficient. Limiting trading activities and holding assets over a longer time horizon results in lower transaction and brokerage fees as well as lower capital gains taxes, as capital gains on assets held for longer than one year taxed at a lower rate than short-term capital gains. Reduced fees and superior tax efficiency make passive investments ideal vehicles for retirement. While investors often overlook trading fees and taxes when deciding where to put their money, these factors can make a big difference over time due to the power of compounding. In fact, historical analysis has shown that passive investments usually outperform active investments over medium and long time horizons, and this is primarily the result of lower tax burdens and transaction costs.
As passive investing has grown in popularity over the past decade, the number of passive investment options available to investors has increased significantly. Index investing, whereby investors purchase a representative “basket” of securities that tracks the performance of a specified benchmark index, such as the S&P 500, is arguably the most common passive investment strategy, however passive investing is not limited to traditional asset classes or even to publicly traded securities.
Commercial Real Estate – The Epitome of Passive Investing
As you might expect, rental properties represent the quintessential passive investment vehicle thanks to their ability to produce cash flow with potentially very little effort required after the initial investment has been made. Countless funds, ETFs, REITs, and online investment platforms allow investors to earn steady income from rental cash flows without having to manage actual properties. While purchasing and operating single-family homes as rentals is one of the most common ways investors invest in real estate, the time commitment involved in managing daily operations reduces suitability as a passive investment tool. Commercial real estate is therefore widely considered the ideal class for passive investing, and there are several additional advantages the commercial sector enjoys over its single-family counterparts as it relates to passive investing.
Greater profit potential: Commercial real estate allows investors to earn more money. Commercial properties are usually larger, supporting higher income streams and offering potential for higher profits on a given deal.
More reliable cash flow: Commercial properties tend to produce more stable cash flow streams than residential properties. While single-family renters often encounter issues that undermine their ability to pay, commercial tenants are typically businesses with greater financial resources and longer leases that reduce the risk of vacancy.
Less competition: The high cost of entry prevents many investors from participating in the commercial real estate markets, creating more opportunities for investors with the capital necessary to acquire large properties. The recent proliferation of commercial real estate-backed funds and investment firms allows savvy investors to gain exposure to the commercial sector without having to contribute large sums of capital.
Commercial Real Estate vs. Stocks
The decision of whether to invest in commercial real estate or stocks is a matter of personal preference, and each carries different risks and opportunities. Investors can generate passive income by holding income-producing dividend stocks or by investing in REITs or real-estate investment funds. Gone are the days when high capital costs excluded the average investor from the real estate markets, and passive investment vehicles are available to investors of all backgrounds, investment objectives, risk tolerances, and styles.
Traditional real estate investments are not as liquid as stocks but tend to provide more predictable and stable income streams. Stocks are generally exposed to a wider variety of risks, including economic, business, political, and regulatory risk that can threaten a company’s ability to pay dividends to shareholders. While many dividend stocks provide reliable income, stock investors typically generate most of their profits from capital gains and it would likely take a considerable investment in a high-yield dividend stock to generate enough income to support a retirement.
Over a long investment horizon, both stocks and real estate have the potential to produce strong returns. Between 2004 and 2019, real estate earned a total return of 260.3% (17.4% annually) compared to 270.5% (18% annually) for stocks. Investors desiring liquidity and opportunities for capital appreciation in the near term may gravitate towards equities, while those seeking steady passive income may prefer real estate. Before deciding where to invest, investors should take time to research alternatives and consider which investment is most suitable given their objectives and tastes.