Passive management

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Passive management is a financial strategy in which a fund manager makes as few portfolio decisions as possible, in order to minimize transaction costs, including the incidence of capital gains tax. One popular method is to mimic the performance of an externally specified index - called 'index funds'. The ethos of an index fund is aptly summed up in the injunction to an index fund manager: "Don't just do something, sit there!"

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. 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 funds, the Vanguard 500, is a passive management fund. The two firms with the largest amounts of money under management: Barclay's Global Investors, and State Street, primarily engage in passive management strategies.

1 Rationale
2 Implementation
3 Statistics and data
- 3.1 Mutual fund investors
4 See also
5 External links

[edit] Rationale

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

The efficient markets hypothesis, which postulates that equilibrium market prices fully reflect all available information. It is widely interpreted as suggesting that it is impossible to systematically "beat the market" through active management.
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.
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 suitable conditions, a fund indexed to "the market" is the only fund investors need. In simplistic term this picture picture sourceshould help you visualize the market risk/volatility involve if your portfolio allocation consists of 50% active management & 50% Passive Management.
Another reason to utilize passive management is summarized by William F. Sharpe, entitled "The Arithmetic of Active Management".

The bull market of the 1990s helped spur the phenomenal 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.

[edit] Implementation

At the simplest, an index fund is implemented by purchasing securities in the same proportion as in the stockmarket 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.

Collective investment schemes that employ passive investment strategies to track the performance of a stockmarket index, are known as index funds. Exchange-traded funds are never actively managed and often track a specific market or commodity indices.

[edit] Statistics and data

Over the last month perhaps 50% of all actively managed funds will "beat the market"; that percentage decreases to 0% looking back 20 or 30 years.

Many people gained 500% in their Nasdaq stocks in 1999, to lose it all the next year. Hedge fund managers that closed their funds in 2000 and 2001 included Tiger Management Corp. and Soros Fund Management.

Some capital managers that have done well for decades, for example Warren Buffett and some private-equity firms like Blackstone and KKR that probably have produced an annualized 20% for the last 20 years.

[edit] Mutual fund investors

Dalbar Inc., a consulting company, found that, during the 16-year period through 2000, the average stock fund returned 14 percent. During that same period, the typical mutual fund investor had a 5.3 percent return. Other studies found similar results.