This article is part of Morningstar's Guide to Passive Investing, helping investors make smart choices to meet their long-term investment goals.
Dan Kemp: Many people are surprised when they discover that Morningstar Investment Management uses passive funds in our portfolios as Morningstar is more typically associated with active fund research, but we think they play a really important role in portfolio construction.
First, they are a great way of harnessing valuation-driven opportunities at a sector, market or even asset class level. Active fund managers often stray from the precise assets that you're trying to access and you don't always get the opportunity you want. But with passive funds you normally know what you're buying.
Second, they are a great way of reducing costs. As Burton Malkiel said, "you can't control what markets do, but you can control the costs you pay." Costs act like a tax on investment. So the lower the costs you pay, the better the returns you're likely to receive.
But it's important to remember that not all passive funds are equal. Research is as important in the passive arena as it is with active funds and we work as closely with the passive fund research team here at Morningstar as we do with their active colleagues. But possibly, the biggest challenge when using passive funds is the shift in responsibility.
When you're using an active fund, the manager not only needs a good investment process but also needs to be able to control the behavioral biases that we all suffer. But when you're using passive funds, that responsibility shifts to you. Unless you are able to control your own behavioral biases then passive funds may do more harm than good.
