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A "buy and hold" passively managed fund would be like an index fund when it comes to buying stocks, but the fund would never sell a stock, say if it's removed from the index. If there's a significant net outflow of money from the fund, the fund would use that as an opportunity to dump stocks that it has in excess of its composition in the index. Until then, it would hold on to the stocks it has.

Selling incurs a transaction cost, and unless one has a reason to believe that the stock is over-valued, why sell it? Since passively-managed funds are built on the premise that the fund manager doesn't have any unique insight into which stocks are over- or under-valued, there's no reason to sell a stock when it's removed from the index. The fund should hold on to what it has, to reduce transaction costs.

What am I missing?

Have there been any empirical studies on whether such a fund has higher returns and/or lower risk?

This idea applies to actively managed funds as well: the fund manager would be free to buy any stock at any time, but not sell, except in response to redemption pressure. Or the fund manager could be given a budget to sell in a given year stocks worth say 1% of the money in the fund.

  • How well do you understand the methodologies used in making indices and that if the fund doesn't sell that it would be deviating from the index that may well make changes regularly? – JB King Nov 22 '15 at 1:38
  • See my comment at JoeTaxpayer's answer and Peter K's comment -- this won't be as much of a problem as you imagine it would be. – Vaddadi Kartick Nov 22 '15 at 4:38
  • "Selling incurs a transaction cost" With the size of these funds, you're probably paying more in fees for their paperclips than their transaction costs. – ceejayoz Nov 24 '15 at 0:57
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Usually, the amswer to "why sell it" is "to maintain the specific distribution balance, or to track the index, that this fund was designed to offer."

A "buy and hold" fund could only buy when users are actively putting money into it. That limits their ability to follow those approaches.

And I think there would be problems msking withdrawls/redeptions "fair", in terms of what shares are sold and how the costs for selling them are distributed, that don't arise for a single buy-and-hold investor.

If you're willing to accept the limitations of the former, and can overcome the latter, it's an interesting idea...

But note that one of the places index funds save money is that, since the composition of indexes changes rately, they are already operating mostly in buy-and-hold mode.It's unclear how much your variant would save.

Worth exploring in greater depth, though. I think.

  • Another source for such a fund for money to buy more shares would be dividends paid by the existing investments. It's not necessary for that revenue stream to be part of a DRIP (dividend reinvestment plan). – Peter K. Nov 21 '15 at 19:01
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    I think your paragraph about indexes changing infrequently is key. Even for an individual investor, "buy and hold" doesn't mean "never sell". You may sell to rebalance, to buy a house, etc. As you say, the low turnover of index funds means they're pretty much buy-and-hold already. – BrenBarn Nov 21 '15 at 19:10
  • A) In addition to Peter K's comment, see my comment at JoeTaxpayer's answer — I think that in most cases, the fund will be able to rebalance itself to track the index better than you imagine. B) Buying a house is outside the scope of this discussion. I thought discussions of "buy and hold" talk about whether you sell one security to buy another, not about whether you sell it to buy a house or pay hospital bills or what have you. That's outside the scope of investment strategy. C) I don't see what fairness problem my fund would have that index or actively managed funds don't have. – Vaddadi Kartick Nov 22 '15 at 4:34
  • D) The costs for any trades are borne by the fund itself, as with any index or actively managed fund. There's nothing different here, again. E) I agree with your point about indices changing rarely, and your conclusion that the "buy and hold" idea is worth exploring in greater depth :) – Vaddadi Kartick Nov 22 '15 at 4:37
  • So if the small-cap index fund had its winners run enough to become mostly large-cap but didn't have inflows, is this now seen as a large-cap fund or does it still get the misleading name given its holdings? – JB King Nov 22 '15 at 21:22
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"Passive" implies following an index. Your question seems to ask about a hypothetical fund that starts, say, as an S&P fund, but as the index is adjusted, the old stocks stay in the fund. Sounds simple enough, but over time, the fund's performance will diverge from the index. The slight potential gain from lack of cap gains will be offset by the fund being unable to market itself.

Keep in mind, the gains distributed each year are almost exclusively long term, taxed at a favorable rate.

  • Let's leave the terminology aside — whether a "buy and hold" fund counts as passive. I used that term because there isn't a human making subjective calls as to what to buy and sell, but the terminology is not important. The fund will be able to market itself if empirical studies show that the buy and hold strategy outperforms index funds as they exist today. Let's leave the tax out of this, since they vary from country to country. – Vaddadi Kartick Nov 22 '15 at 4:16
  • The fund's performance will diverge over time only if inflows and outflows are exactly matched every month. If the fund has a lot of net inflow for a few months or longer, it can use that money to buy stocks that it's underweight in. Likewise, if there's a lot of net outflow for a few months or longer, it can liquidate stocks it's overweight in to satisfy redemptions. In both cases, the fund will get closer to tracking the index. So I think this will be a far smaller problem than you think it will be. – Vaddadi Kartick Nov 22 '15 at 4:29
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They pretty much already have what you are looking for. They are called Unit Investment Trusts. The key behind these is (a) the trust starts out with a fixed pool of securities. It is completely unmanaged and there is no buying or selling of the securities, (b) they terminate after a fixed period of time, at which time all assets are distributed among the owners.

According to Investment Company Institute, "securities in a UIT are professionally selected to meet a stated investment objective, such as growth, income, or capital appreciation." UITs sell a fixed number of units at one-time public offering. Securities in a UIT do not trade actively, rather, UITs use a strategy known as buy-and-hold. The UIT purchases a certain amount of securities and holds them until its termination date. Holdings rarely change
throughout the life of the trust so unit holders know exactly what they're investing in, and the trust lists all securities in its prospectus. Unit trusts normally sell redeemable units - this obligates the trust to re-purchase investor's units at their net asset value at the investors request.

  • Interesting. My idea is different, though, because it's open-ended: A) You can invest in the fund at any time. B) The fund doesn't have a fixed termination date. C) Because money keeps flowing in throughout the life of the fund, the fund keeps buying stocks throughout its life, and not just at the start. D) The fund buys stocks with a goal of conforming to an index as closely as possible — not subjectively. E) And you don't know ahead of time what stocks the fund will invest in and in what proportion, since it depends on future changes to the index, and cash flows. – Vaddadi Kartick Nov 22 '15 at 4:26

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