1. Rationale

2. Implementation

3. Pension fund investment in passive strategies

4. Criticism

5. See also

6. References

7. Further reading

8. External links

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.^[4]

One of the largest equity mutual funds, the Vanguard 500, is passively managed.^[4] The two firms with the largest amounts of money under management, BlackRock and State Street, primarily engage in passive management strategies.

Rationale

The concept of passive management is counterintuitive to many investors.^[4][5] The rationale behind indexing stems from the following concepts of financial economics:^[4]

1. 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.^{&91;1&93;&91;6&93;}
2. 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 management,^&91;7&93; 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.
3. 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.^{&91;8&93;&91;9&93;}
4. 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 some very strong assumptions, a fund indexed to "the market" is the only fund investors need to obtain the highest risk-adjusted return possible.^&91;4&93; Note that the CAPM has been roundly rejected by empirical tests.

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.^[4][10]

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.^[4]

Some active managers may beat the index in particular years, or even consistently over a series of years.^[11] 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.^[12]

Implementation

At the simplest, an index fund is implemented by purchasing securities in the same proportion as in the stock market index.^[12] 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.

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.^[12] The report noted that passive portfolios diversified in international asset classes generate more stable returns, particularly if rebalanced regularly.^[12]

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 large number of shares.

Being forced to own stock on certain companies by the funds' charters, State Street pressures about principles of diversity, including gender diversity.^[16]

The Bank of America estimated 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.^[17] Similarly, Vanguard stated in 2018 that index funds own "15% of the value of all global equities".^[18]

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 ^[19] The proportion invested in passive funds varies widely across jurisdictions and fund type ^[19][20]

The relative appeal of passive funds such as ETFs and other index-replicating investment vehicles has grown rapidly ^[21] for various reasons ranging from disappointment with underperforming actively managed mandates ^[19] to the broader tendency towards cost reduction across public services and social benefits that followed the 2008-2012 Great Recession.^[22] Public-sector pensions and national reserve funds have been among the early adopters of passive management strategies.^[20][22]

Criticism

Analysts at Sanford C. Bernstein & Co., LLC have criticized passive management as worse than Marxism.^[23]

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.

Analysts at Emperor Investments,Inc. argue that by the law of unintended consequences the rise of passive investing makes the market more and more inefficient, which in turn makes active investing more profitable. ^[24]

See also

• Investment management
• Active management
• Exchange-traded fund
• Buy and hold
• Index fund
• Enhanced indexing
• Relative return
• Value investing

References

Further reading

• 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}}
• M. Nicolas J. Firzli, "Passive Play: Disenchanted Asset Owners Going Low-Cost as the ‘Age of Austerity’ Lingers", Revue Analyse Financière 54 (2015): 68-70.
• Mark T. Hebner, Index Funds: The 12-Step Program for Active Investors, IFA Publishing, 2007, {{ISBN|0-9768023-0-9}}

External links

• The Active vs Passive - unresolved issues.
• The Future of Investment Management
• [https://www.bogleheads.org/wiki/Lazy_portfolios Lazy portfolios on Bogleheads.org]
• Long run investing simulators at MarketLongRun.com

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