Passive management (also called passive investing) is a financial strategy in which a fund manager makes as few portfolio decisions as possible, in order to minimize transaction costs, including the incidence of capital gains tax. One popular method is to mimic the performance of an externally specified index—called 'index funds'. The ethos of an index fund is aptly summed up in the injunction to an index fund manager: "Don't just do something, sit there!"
Passive management is most common on the equity market, where index funds track a stock market index, but it is becoming more common in other investment types, including bonds, commodities and hedge funds. Today, there is a plethora of market indexes in the world, and thousands of different index funds tracking many of them.
One of the largest equity mutual funds, the Vanguard 500, is a passive management fund. The two firms with the largest amounts of money under management, Barclays Global Investors and State Street Corp., primarily engage in passive management strategies.
Rationale
The concept of passive management is counterintuitive to many investors. The rationale behind indexing stems 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.[1].
- The efficient market hypothesis, which postulates that equilibrium market prices fully reflect all available information. It is widely interpreted as suggesting that it is impossible to systematically "beat the market" through active management, although this is not a correct interpretation of the hypothesis in its weak form. Stronger forms of the hypothesis are extremely controversial, and there is some debatable evidence against it in its weak form too. For further information see behavioural finance
- 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 appetite, 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.
The bull market of the 1990s helped spur the phenomenal growth in indexing observed over that decade. Investors were able to achieve desired absolute returns simply by investing in portfolios benchmarked to broad-based market indices such as the S&P 500, Russell 3000, and Wilshire 5000.
In the United States, indexed funds have outperformed the majority of active managers, especially as the fees they charge are very much lower than active managers. They are also able to have significantly greater after-tax returns.
Some active managers may beat the index in particular years, or even consistently over a series of years. Nevertheless the retail investor still has the problem of discerning how much of the outperformance was due to skill rather than luck, and which managers will do well in the future.
Implementation
At the simplest, an index fund is implemented by purchasing securities in the same proportion as in the stock market index. It can also be achieved by sampling (e.g. buying stocks of each kind and sector in the index but not necessarily some of each individual stock), and there are sophisticated versions of sampling (e.g. those that seek to buy those particular shares that have the best chance of good performance).
Investment funds run by Investment managers who closely mirror the index in their managed portfolios and offer little "added value" as managers whilst charging fees for active management are called 'closet trackers'; that is they do not in truth actively manage the fund but furtively mirror the index.
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 are never actively managed and often track a specific market or commodity indices.
Globally diversified portfolios of index funds are used by investment advisors who invest passively for their clients.
Mutual fund investors
Dalbar Inc., a market research company, found that during the 20 years from 1984 to 2004, the average stock fund investor earned returns of only 3.7% per year, while the S&P 500 returned 13.2%. On an inflation adjusted return, the average equity fund investor earned $13,835 on a $100,000 investment made in 1985, while the inflation adjusted return of the S&P 500 would have been $591,337 or 43 times greater.
See also
References
- Burton G. Malkiel, A Random Walk Down Wall Street, W. W. Norton, 1996, ISBN 0-393-03888-2
- John Bogle, Bogle on Mutual Funds: New Perspectives for the Intelligent Investor, Dell, 1994, ISBN 0-440-50682-4
- Mark T. Hebner, Index Funds: The 12-Step Program for Active Investors, IFA Publishing, 2007, ISBN 0-976-80230-9
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