) is an investing strategy that tracks a market-weighted index or portfolio.The most popular method is to mimic the performance of an externally specifiedindexby buying anindex fund. By tracking an index, an investment portfolio typically gets good diversification, low turnover (good for keeping down internaltransaction costs), 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.
Passive management is most common on theequity market, where index funds track astock market index, but it is becoming more common in other investment types, includingbondscommoditiesandhedge funds.4
One of the largest equitymutual funds, theVanguard 500, is passively managed.4The two firms with the largest amounts of money under management,BlackRockandState Street, primarily engage in passive management strategies.
The concept of passive management iscounterintuitiveto many investors.45The rationale behind indexing stems from the following concepts of financial economics:4
In thelong 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.
Theefficient-market hypothesispostulates 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 throughactive management,
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 seebehavioural finance.
Theprincipalagent problem: aninvestor(the principal) who allocates money to a portfolio manager (the agent) must properly giveincentivesto the manager to run the portfolio in accordance with the investorsriskreturnappetite, and must monitor the managers performance.
Thecapital asset pricing model(CAPM) and related portfolio separation theorems, which imply that, in equilibrium, all investors will hold a mixture of themarket portfolioand a riskless asset. That is, under some very strong assumptions, a fund indexed to the market is the only fund investors need to obtain the highest risk-adjusted return possible.
Note that the CAPM has been roundly rejected by empirical tests.
Thebull marketof the 1990s helped spur the growth in indexing observed over that decade. Investors were able to achieve desiredabsolute returnssimply by investing in portfolios benchmarked to broad-based market indices such as theS&P 500Russell 3000, andWilshire 5000.410
In theUnited States, indexed funds have outperformed the majority of active managers, especially as thefeesthey charge are very much lower than active managers. They are also able to have significantly greater after-taxreturns. This holds true when comparing both, mutual fund and the passive benchmark with the money market account, but changes by taking differential returns into account.411
Some active managers may beat the index in particular years, or even consistently over a series of years.12Nevertheless, 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.13
At the simplest, anindex fundis implemented by purchasingsecuritiesin the same proportion as in thestock market index.13It can also be achieved by sampling (e.g., buyingstocksof 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 byinvestment managerswho 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 fundsthat employ passive investment strategies to track the performance of astock market indexare known asindex funds.14Exchange-traded fundsare 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.1516
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. ALoring Wardreport in Advisor Perspectives showed how international diversification worked over the 10-year period from 20002010, 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.13The report noted that passive portfolios diversified in international asset classes generate more stable returns, particularly if rebalanced regularly.13
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 Advisorshas long engaged companies on issues ofcorporate governance. Passive managers can vote against aboard of directorsusing a large number of shares. Being forced to own stock on certain companies by the funds charters, State Street pressures about principles of diversity, includinggender diversity.17
TheBank of Americaestimated in 2017 that 37 percent of the value of U.S. funds (not including privately held assets) were in passive investments such as index funds and index ETFs. The same year, BlackRock estimated that 17.5 percent of the global stock market was managed passively; in contrast, 25.6 percent was managed by active funds or institutional accounts, and 57 percent was privately held and presumably does not track an index.18Similarly, Vanguard stated in 2018 that index funds own 15% of the value of all global equities.19
Research conducted by theWorld Pensions Council (WPC)suggests that 15% to 20% of overall assets held by largepension fundsand nationalsocial securityfunds 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.20The proportion invested in passive funds varies widely across jurisdictions and fund type.2021
The relative appeal of passive funds such asETFsand other index-replicating investment vehicles has grown rapidly22for various reasons ranging from disappointment with underperforming actively managed mandates20to the broader tendency towardscost reductionacross public services and social benefits that followed the 2008-2012Great Recession.23Public-sector pensions and nationalreservefunds have been among the early adopters of passive management strategies.2123
Analysts atSanford C. Bernstein & Co., LLChave criticized passive management as worse thanMarxism.24In their 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.
Analysts at Emperor Investments,Inc. argue that by the law ofunintended consequencesthe rise of passive investing makes the market more and more inefficient, which in turn makes active investing more profitable.25
A number of other prominent investors have criticized passive management on a variety of grounds.Carl IcahnHoward MarksandMichael Burryargue that passive indexing has led to distortion of stock prices or abubble, particularly in the price oflarge companystocks; while Nobel Prize winnerRobert Shillerdescribed passive indexing as a chaotic system.2627Jeffrey Gundlachasserts that passive management has become a mania and an example ofherding behavior.28Jack Bogle, who popularized passive investing in the 1970s with Vanguard, raised concerns in 2018 about the three largest US passive investing firms (Vanguard, BlackRock and State Street) holding a disproportionate share of voting control over US corporations.29
Sharpe, William.The Arithmetic of Active Management.
Asness, Clifford S.; Frazzini, Andrea; Israel, Ronen; Moskowitz, Tobias J. (June 1, 2015). Fact, Fiction, and Value Investing. Rochester, NY.SSRN
William F. Sharpe,Indexed Investing: A Prosaic Way to Beat the Average Investor. May 1, 2002. Retrieved May 20, 2010.
Burton G. Malkiel, A Random Walk Down Wall Street, W. W. Norton, 1996,
Passive investing is now the mainstream method, says Morningstar researcherMarketWatch
John Y. Campbell, Strategic Asset Allocation: Portfolio Choice for Long-Term vited address to the American Economic Association and American Finance Association. Atlanta, Georgia, January 4, 2002. Retrieved May 20, 2010
Efficient Market Hypothesis – EMH. Investopedia
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Mark T. Hebner, IFA Publishing. Index Funds: The 12-Step Program for Active Investors, 2007,
Frahm, G.; Huber, F.The Outperformance Probability of Mutual Funds. J. Risk Financial Manag. 2019, 12, 108.doi:10.3390/jrfm12030108
John Bogle, Bogle on Mutual Funds: New Perspectives for the Intelligent Investor, Dell, 1994,
The Backstory Behind That Fearless Girl Statue on Wall StreetBethany McLean, Mar 13, 2017,The Atlantic.
Less than 18 percent of global stocks owned by index investors: BlackRock.
Sheetz, Michael (December 17, 2018).Gundlach says passive investing has reached mania status.
Rachael Revesz (November 27, 2013).Why Pension Funds Wont Allocate 90 Percent To Passives.
Chris Flood (May 11, 2014).Alarm Bells Ring for Active Fund Managers.
Mike Foster (June 6, 2014).Institutional Investors Look to ETFs.
Rachael Revesz (May 7, 2014).UK Govt. Leading Way For Pensions Using Passives.
Bernstein: Passive Investing Is Worse for Society Than MarxismLuke Kawa, August 23, 2016,Blooomberg Markets
Passive Investing Could Soon Be Inefficient, Emperor Investments Inc. Retrieved February 17, 2019
Carmen Reinicke (Aug 29, 2019).Big Short investor Michael Burry is calling passive investment a bubble. Hes not the only finance luminary sounding the alarm.Business Insider, accessed 31 August 2019
Michael Sheetz (17 December 2018).Jeffrey Gundlach says passive investing has reached a mania investors should avoid index fundsCNBC.com, accused 31 August 2019
Erin Arvedlund (08 December 2018)Vanguard founder John Bogle warns index funds becoming too big, accessed 31 August 2019
Burton G. MalkielA Random Walk Down Wall StreetW. W. Norton, 1996,
Bogle on Mutual Funds: New Perspectives for the Intelligent Investor
Passive Play: Disenchanted Asset Owners Going Low-Cost as the Age of Austerity Lingers
Index Funds: The 12-Step Program for Active Investors
Loan qualifying investor alternative investment fund(LQIAIF)
Qualifying investor alternative investment fund(QIAIF)
This page was last edited on 6 November 2019, at 08:41