This Site Requires Javascript
Burger Menu

Passive Investing

Additional Resources

  1. On The Economic Consequences Of Index-linked Investing [pages.stern.nyu.edu]
  2. Indexed Investing [web.stanford.edu]
  3. Passive Over Active Investing [econ411w14.lsa.umich.edu]
  4. Active Vs. Passive Investing: Which Approach Offers Better Returns? [executiveeducation.wharton.upenn.edu]
  5. Comparing Active And Passive Fund Management In Emerging Markets [econ.berkeley.edu]
  6. Passive Investing: The Role Of Securities Lending [darden.virginia.edu]

Definition

Passive management is an investing strategy that tracks a market-weighted index or portfolio. 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. investors typically do this by buying one or more index funds. By tracking an index, an investment portfolio typically gets good diversification, low turnover, and low management fees. With low 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.

Source: Wikipedia
This Article has been Edited for Accessibility

Rationale

The concept of passive management is counterintuitive to many investors. The rationale behind indexing stems from the following concepts of financial economics:

The bull market of the 1990s helped spur the 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.

Investment funds that employ passive investment strategies to track the performance of a stock market index are known as index funds. Exchange-traded funds are hardly ever actively managed and often track a specific market or commodity indices. Using a small number of index funds and ETFs, one can construct a portfolio that tracks global equity and bond market at a relatively low cost. Popular examples include two-fund and three-fund lazy portfolios.

Globally diversified portfolios of index funds are used by investment advisors who invest passively for their clients based on the principle that underperforming markets will be balanced by other markets that outperform. A Loring Ward report in Advisor Perspectives showed how international diversification worked over the 10-year period from 2000–2010, with the Morgan Stanley Capital Index for emerging markets generating ten-year returns of 154 percent balancing the blue-chip S&P 500 index, which lost 9.1 percent over the same period – a historically rare event. The report noted that passive portfolios diversified in international asset classes generate more stable returns, particularly if rebalanced regularly.

There is room for dialog about whether index funds are one example of or the only example of passive management.

"Passive" management does not mean hands-off. State Street Global Advisors has long engaged companies on issues of corporate governance. Passive managers can vote against a board of directors using a big amount of shares. Being forced to own stock on certain companies by the funds' charters, State Street pressures about principles of diversity, including gender diversity.

Pension fund investment in passive strategies

Research conducted by the World Pensions Council (WPC) suggests that 15% to 20% of overall assets held by large pension funds and national social security funds are invested in various forms of passive funds- as opposed to the more traditional actively managed mandates which still constitute the largest share of institutional investments The proportion invested in passive funds varies widely across jurisdictions and fund type

The relative appeal of passive funds such as ETFs and other index-replicating investment vehicles has grown rapidly for various reasons ranging from disappointment with underperforming actively managed mandates to the broader tendency towards cost reduction across public services and social benefits that followed the 2008-2012 Great Recession. Public-sector pensions and national reserve funds have been among the early adopters of passive management strategies.

Criticism

Analysts at Sanford C. Bernstein & Co., LLC have criticized passive management as worse than Marxism. In that view, active market management and Marxism try to allocate resources optimally, while passive management increases correlation of stocks and impedes efficiency. Therefore, they advise policymakers to not undermine active management.