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Passive Management

Definition

Passive management is an investing strategy that tracks a market-weighted index or portfolio. The most popular method is to mimic the performance of an externally specified index by buying an index fund. 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.

What is 'Passive Management'

Passive management is a style of management associated with mutual and exchange-traded funds (ETF) where a fund's portfolio mirrors a market index. Passive management is the opposite of active management in which a fund's manager(s) attempt to beat the market with various investing strategies and buying/selling decisions of a portfolio's securities. Passive management is also referred to as "passive strategy," "passive investing" or " index investing."

Explaining 'Passive Management'

Followers of passive management believe in the efficient market hypothesis. It states that at all times markets incorporate and reflect all information, rendering individual stock picking futile. As a result, the best investing strategy is to invest in index funds, which have historically outperformed the majority of actively managed funds.

The Research Behind Passive Management

In the 1960s, University of Chicago professor of economics, Eugene Fama, conducted extensive research on stock price patterns, which led to his development of the Efficient Market Hypothesis (EMH). The EMH maintains that market prices fully reflect all available information and expectations, so current stock prices are the best approximation of a company’s intrinsic value. Attempts to systematically identify and exploit stocks that are mispriced on the basis of information typically fail because stock price movements are largely random and are primarily driven by unforeseen events. Although mispricing can occur, there is no predictable pattern for their occurrence that results in consistent outperformance. The efficient markets hypothesis implies that no active investor will consistently beat the market over long periods of time, except by chance, which means active management strategies using stock selection and market timing cannot consistently add value enough to outperform passive management strategies.


Further Reading


Passive investment strategies and efficient markets
onlinelibrary.wiley.com [PDF]
… Investors are likely to achieve far higher returns by employing a passive indexing strategy than they are likely to achieve from … Kahneman, D. and Riepe, MW, 'Aspects of investor psychology', Journal of Portfolio Management, Vol … (eds) Handbook of the Economics of Finance …

Hidden power of the Big Three? Passive index funds, re-concentration of corporate ownership, and new financial riskHidden power of the Big Three? Passive index funds, re-concentration of corporate ownership, and new financial risk
www.cambridge.org [PDF]
… Investors are likely to achieve far higher returns by employing a passive indexing strategy than they are likely to achieve from … Kahneman, D. and Riepe, MW, 'Aspects of investor psychology', Journal of Portfolio Management, Vol … (eds) Handbook of the Economics of Finance …

Asset management fees and the growth of financeAsset management fees and the growth of finance
www.aeaweb.org [PDF]
… Investors are likely to achieve far higher returns by employing a passive indexing strategy than they are likely to achieve from … Kahneman, D. and Riepe, MW, 'Aspects of investor psychology', Journal of Portfolio Management, Vol … (eds) Handbook of the Economics of Finance …

Active vs. passive management: New evidence from exchange traded fundsActive vs. passive management: New evidence from exchange traded funds
papers.ssrn.com [PDF]
… Investors are likely to achieve far higher returns by employing a passive indexing strategy than they are likely to achieve from … Kahneman, D. and Riepe, MW, 'Aspects of investor psychology', Journal of Portfolio Management, Vol … (eds) Handbook of the Economics of Finance …

Steering capital: the growing private authority of index providers in the age of passive asset managementSteering capital: the growing private authority of index providers in the age of passive asset management
www.tandfonline.com [PDF]
… Investors are likely to achieve far higher returns by employing a passive indexing strategy than they are likely to achieve from … Kahneman, D. and Riepe, MW, 'Aspects of investor psychology', Journal of Portfolio Management, Vol … (eds) Handbook of the Economics of Finance …

The shift from active to passive investing: potential risks to financial stability?The shift from active to passive investing: potential risks to financial stability?
papers.ssrn.com [PDF]
… Investors are likely to achieve far higher returns by employing a passive indexing strategy than they are likely to achieve from … Kahneman, D. and Riepe, MW, 'Aspects of investor psychology', Journal of Portfolio Management, Vol … (eds) Handbook of the Economics of Finance …

Economic implications of passive investingEconomic implications of passive investing
link.springer.com [PDF]
… Investors are likely to achieve far higher returns by employing a passive indexing strategy than they are likely to achieve from … Kahneman, D. and Riepe, MW, 'Aspects of investor psychology', Journal of Portfolio Management, Vol … (eds) Handbook of the Economics of Finance …

The value of management flexibility—a real option approach to investment evaluationThe value of management flexibility—a real option approach to investment evaluation
www.sciencedirect.com [PDF]
… Investors are likely to achieve far higher returns by employing a passive indexing strategy than they are likely to achieve from … Kahneman, D. and Riepe, MW, 'Aspects of investor psychology', Journal of Portfolio Management, Vol … (eds) Handbook of the Economics of Finance …

Passive investors, not passive ownersPassive investors, not passive owners
www.sciencedirect.com [PDF]
… Investors are likely to achieve far higher returns by employing a passive indexing strategy than they are likely to achieve from … Kahneman, D. and Riepe, MW, 'Aspects of investor psychology', Journal of Portfolio Management, Vol … (eds) Handbook of the Economics of Finance …



Q&A About Passive Management


Where are most of the money invested in passive investments?

The bulk of money in passive index funds are invested with these three companies.

What is passive management?

Passive management is a style of management associated with mutual and exchange-traded funds where a fund's portfolio mirrors a market index.

What does it mean to say an investment strategy cannot "consistently" add value en"?

It means investors cannot expect to make money from this strategy over time if they do not have some luck along the way.

How much money has been shifted into passive investments from assets over time?

A major shift from assets to passive investments has occurred over time.

What does passive management do?

Passive management allows investors to get good diversification, low turnover (good for keeping down internal transaction costs), and low fees.

What does passive management oppose?

Passive management opposes active investing.

Who developed the efficient market hypothesis?

Eugene Fama developed the Efficient Market Hypothesis (EMH). The EMH maintains that market prices fully reflect all available information and expectations, so current stock prices are the best approximation of a company's intrinsic value. Attempts to systematically identify and exploit stocks that are mispriced on the basis of information typically fail because stock price movements are largely random and are primarily driven by unforeseen events. Although mispricing can occur, there is no predictable pattern for their occurrence that results in consistent outperformance. The efficient markets hypothesis implies that no active investor will consistently beat the market over long periods of time, except by chance, which means active management strategies using stock selection and market timing cannot consistently add value en""

Who are the three major players in passive investment?

Black Rock, Vanguard, and State Street.