Passive management (also called passive investing) is a financial strategy in which an investor (or a fund manager) invests in accordance with a pre-determined strategy that doesn’t entail any forecasting (e.g., any use of market timing or stock picking would not qualify as passive management). The idea is to minimize investing fees and to avoid the adverse consequences of failing to correctly anticipate the future. The most popular method is to mimic the performance of an externally specified index. Retail investors typically do this by buying one or more “index funds”. By tracking an index, an investment portfolio typically gets good diversification*, low turnover (good for keeping down internal transaction costs), and extremely low management fees. With low management fees, an investor in such a fund would have higher returns than a similar fund with similar investments but higher management fees and/or turnover/transaction costs.
Rationale
The concept of passive management is counterintuitive to many investors but it is derived from five concepts of financial economics:
- In the long term, the average investor will have an average before-costs performance equal to the market average. Therefore the average investor will benefit more from reducing investment costs than from trying to beat the average.
- The efficient market hypothesis postulates that equilibrium market prices fully reflect all available information, or to the extent there is some information not reflected, there is nothing that can be done to exploit that fact. It is widely interpreted as suggesting that it is impossible to systematically “beat the market” through active investing.
- The principal-agent problem: an investor (the principal) who allocates money to a portfolio manager (the agent) must properly give incentives to the manager to run the portfolio in accordance with the investor’s risk/return profile, and must monitor the manager’s performance.
- The local elasticity of the market, while usually theorized not to be conducive to any particular investment strategy, can in fact be favorable in many cases to a stable strategy, setting passive management apart from its more change-prone counterparts.
- The capital asset pricing model (CAPM) and related portfolio separation theorems, which imply that, in equilibrium, all investors will hold a mixture of the market portfolio and a riskless asset. That is, under suitable conditions, a fund indexed to “the market” is the only fund investors need.
* Diversification does not guarantee a profit or ensure against loss.
Implementation
At the simplest, an index fund is implemented by purchasing securities in the same proportion as in the stock/bond market index. It can also be achieved by sampling (e.g. buying stocks/bonds of each kind and sector in the index but not necessarily some of each individual stock/bond).
Collective investment schemes that employ passive investment strategies to track the performance of a stock market index, are known as index funds. Exchange traded funds (ETFs) are never actively managed and often track a specific market or commodity indices.
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