Passive management
Encyclopedia
Passive management 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 fund
s'. 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.
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 bond
s, commodities and hedge fund
s. 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 fund
s, 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.
to many investors. The rationale behind indexing stems from five concepts of financial economics:
The bull market of the 1990s helped spur the phenomenal growth in indexing observed over that decade. Investors were able to achieve desired absolute return
s 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 fee
s 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.
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 stock
s 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 scheme
s that employ passive investment strategies to track the performance of a stock market index
, are known as index fund
s. Exchange-traded fund
s 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 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.
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. An analysis of the equity funds returns of the 15 biggest asset management companies worldwide from 2004 to 2009 showed that about 80% of the actively managed funds for US, European and Asian equities have returned below their respective benchmarks.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
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
Market timing
Market timing is the strategy of making buy or sell decisions of financial assets by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis...
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
Index (economics)
In economics and finance, an index is a statistical measure of changes in a representative group of individual data points. These data may be derived from any number of sources, including company performance, prices, productivity, and employment. Economic indices track economic health from...
. Retail investors typically do this by buying one or more 'index fund
Index fund
An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.-Tracking:Tracking can be achieved by trying to hold all of the...
s'. 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.
Passive management is most common on the equity market
Stock market
A stock market or equity market is a public entity for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.The size of the world stock market was estimated at about $36.6 trillion...
, where index funds track a stock market index
Stock market index
A stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks, to measure the performance of portfolios such as mutual funds....
, but it is becoming more common in other investment types, including bond
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
s, commodities and hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
s. 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 fund
Mutual fund
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.- Overview :...
s, 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.
State Street Corp.
State Street Corporation, or simply State Street, is a U.S.-based financial services holding company. State Street was founded in 1792, and is headquartered in the Financial District area of Boston at One Lincoln Street...
, primarily engage in passive management strategies.
Rationale
The concept of passive management is counterintuitiveCounterintuitive
The word "counterintuitive" literally means counter to intuition, and so it essentially means that something does not seem right or correct.A counterintuitive proposition is one that does not seem likely to be true when assessed using intuition or gut feelings...
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.
- 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 managementActive managementActive management refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index...
, although this is not a correct interpretation of the hypothesis in its weak form. Stronger forms of the hypothesis are 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 investorInvestmentInvestment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
(the principal) who allocates money to a portfolio manager (the agent) must properly give incentiveIncentiveIn economics and sociology, an incentive is any factor that enables or motivates a particular course of action, or counts as a reason for preferring one choice to the alternatives. It is an expectation that encourages people to behave in a certain way...
s to the manager to run the portfolio in accordance with the investor's risk/returnReturn on investmentReturn on investment is one way of considering profits in relation to capital invested. Return on assets , return on net assets , return on capital and return on invested capital are similar measures with variations on how “investment” is defined.Marketing not only influences net profits but also...
appetite, and must monitor the manager's performance. - The local elasticityElasticity (economics)In economics, elasticity is the measurement of how changing one economic variable affects others. For example:* "If I lower the price of my product, how much more will I sell?"* "If I raise the price, how much less will I sell?"...
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 stableStableA stable is a building in which livestock, especially horses, are kept. It most commonly means a building that is divided into separate stalls for individual animals...
strategy, setting passive management apart from its more change-prone counterparts. - The capital asset pricing modelCapital asset pricing modelIn finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
(CAPM) and related portfolio separation theorems, which imply that, in equilibrium, all investors will hold a mixture of the market portfolioMarket portfolioMarket portfolio is a portfolio consisting of a weighted sum of every asset in the market, with weights in the proportions that they exist in the market, with the necessary assumption that these assets are infinitely divisible....
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 return
Absolute return
The absolute return or simply return is a measure of the gain or loss on an investment portfolio expressed as a percentage of invested capital. The adjective absolute is used to stress the distinction with the relative return measures often used by long-only equity funds, i.e...
s simply by investing in portfolios benchmarked to broad-based market indices such as the S&P 500
S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
, Russell 3000
Russell 3000
The Russell 3000 Index is a stock market index of US stocks.The ticker symbol is ^RUA.This index measures the performance of 3,000 publicly held US companies based on total market capitalization, which represents approximately 98% of the investable US market.-Annual returns reflected by the Russell...
, and Wilshire 5000
Wilshire 5000
The Wilshire 5000 Total Market Index, or more simply the Wilshire 5000, is a market-capitalization-weighted index of the market value of all stocks actively traded in the United States. Currently, the index contains over 4,100 components...
In the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
, indexed funds have outperformed the majority of active managers, especially as the fee
Fee
A fee is the price one pays as remuneration for services. Fees usually allow for overhead, wages, costs, and markup.Traditionally, professionals in Great Britain received a fee in contradistinction to a payment, salary, or wage, and would often use guineas rather than pounds as units of account...
s they charge are very much lower than active managers. They are also able to have significantly greater after-tax
Tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...
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 fundIndex fund
An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.-Tracking:Tracking can be achieved by trying to hold all of the...
is implemented by purchasing securities
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
in the same proportion as in the stock market index
Stock market index
A stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks, to measure the performance of portfolios such as mutual funds....
. It can also be achieved by sampling (e.g. buying stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
s 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 scheme
Collective investment scheme
A collective investment scheme is a way of investing money alongside other investors in order to benefit from the inherent advantages of working as part of a group...
s that employ passive investment strategies to track the performance of a stock market index
Stock market index
A stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks, to measure the performance of portfolios such as mutual funds....
, are known as index fund
Index fund
An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.-Tracking:Tracking can be achieved by trying to hold all of the...
s. Exchange-traded fund
Exchange-traded fund
An exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...
s 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 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.
Mutual fund investors
Dalbar Inc., a market researchMarket research
Market research is any organized effort to gather information about markets or customers. It is a very important component of business strategy...
company, found that during the 20 years from 1984 to 2004, the average stock fund
Stock fund
A stock fund or equity fund is a fund that invests in equities more commonly known as stocks. Stock funds are contrasted with bond funds and money funds. Fund assets are typically mainly in stock, with some amount of cash, which is generally quite small, as opposed to bonds, notes, or other...
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. An analysis of the equity funds returns of the 15 biggest asset management companies worldwide from 2004 to 2009 showed that about 80% of the actively managed funds for US, European and Asian equities have returned below their respective benchmarks.
See also
- Exchange-traded fundExchange-traded fundAn exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...
- Investment managementInvestment managementInvestment management is the professional management of various securities and assets in order to meet specified investment goals for the benefit of the investors...
- Active managementActive managementActive management refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index...
- Buy and holdBuy and holdBuy and hold is a long-term investment strategy based on the view that in the long run financial markets give a good rate of return despite periods of volatility or decline. This viewpoint also holds that short-term market timing, i.e...
- Index investing
- Enhanced indexingEnhanced IndexingIn finance, enhanced indexing is a catch-all term that describes strategies employed to outperform traditional indexing. Enhanced indexing attempts to generate modest excess returns compared to index funds and other passive management techniques.-Features:...
- Relative returnRelative returnRelative return is a measure of the return of an investment portfolio relative to a theoretical passive reference portfolio or benchmark.In active portfolio management, the aim is to maximize the relative return...
- Value investingValue investingValue investing is an investment paradigm that derives from the ideas on investment and speculation that Ben Graham and David Dodd began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 text Security Analysis...
External links
- March 2004 - The Future of Investment Management - article
- Active vs. Passive - does Passive Outperform