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.
Key Takeaways
- Passive management is a reference to index funds and exchange-traded funds that mirror an established index, such as the S&P 500.
- Passive management is the opposite of active management, in which a manager selects stocks and other securities to include in a portfolio.
- Passively managed funds tend to charge lower fees to investors than funds that are actively managed.
- The Efficient Market Hypothesis (EMH) demonstrates that no active manager can beat the market for long, as their success is only a matter of chance; longer-term, passive management delivers better returns.
Understanding 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. Passive management is also referred to as "passive strategy," "passive investing," or " index investing."
Vanguard 500 Index Fund Admiral Shares, Vanguard Total International Stock Index Fund, and Vanguard Total Stock Market Index Fund Admiral Shares are the three largest index funds.
The Research Behind Passive Management
In the 1960s, the University of Chicago's professor of economics, Eugene Fama, conducted extensive research on stock price patterns, which led to his development of the Efficient Capital 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 based on 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.
William F. Sharpe concluded that, as a whole, active fund managers underperform passive fund managers, not because there is anything inherently wrong in their financial strategies, but simply because of the laws of arithmetic. For active managers to outperform the market, they have to achieve a return that can overcome their fund expenses, which are much higher than passive funds due to higher management fees, higher trading costs, and higher turnover. This is consistent with Sharpe’s research, which shows that, as a group, active managers underperform the market by an amount equivalent to their average fees and expenses.
When a passive management strategy is employed, there is no need to expend time or resources on the stock selection or market timing. Because of the short-term randomness of returns, investors would be better served through a passive, structured portfolio based on asset class diversification to manage uncertainty and position the portfolios for long-term growth in the capital markets.
$1.2 trillion
The amount that poured into passive funds in 2021, according to the latest figures from fund tracker Morningstar.
Ongoing Rush to Passive Management
Due to poor returns of active management and the recommendation of influential financiers like Warren Buffett, investor cash has flooded into passive management in recent years. In 2021 alone,$1.2 trillion poured into passive U.S. equity funds, according to fund tracker Morningstar. Conversely,as of April 2002, over the last five years $86.4 billion fled actively managed funds. However, much of the influx to passive funds flowed to taxable and municipal bond funds.
FAQs
Passive managers generally believe it is difficult to out-think the market, so they try to match market or sector performance. Passive investing attempts to replicate market performance by constructing well-diversified portfolios of single stocks, which if done individually, would require extensive research.
What is the passive approach to management? ›
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. The most popular method is to mimic the performance of an externally specified index by buying an index fund.
What is the meaning of passively managed? ›
Key Takeaways
Passive management is a reference to index funds and exchange-traded funds that mirror an established index, such as the S&P 500. Passive management is the opposite of active management, in which a manager selects stocks and other securities to include in a portfolio.
What is passive management in business? ›
The purpose of passive portfolio management is to generate a return that is the same as the chosen index. A passive strategy does not have a management team making investment decisions and can be structured as an exchange-traded fund (ETF), a mutual fund, or a unit investment trust (UIT).
What is an example of passive management? ›
Passive Management
In these types of funds, the mutual fund company buys and sells stocks to match or approximate a market index or benchmark. For example, one mutual fund portfolio might attempt to mirror the S&P 500 stock market index. Stocks are bought and sold according to what companies are listed in the index.
What are the two main passive management techniques? ›
Similarly, there are two main types of passively-managed investments: Funds: passively-managed funds track an index, such as the FTSE 100 or S&P Global 500. Exchange-traded funds (ETFs): Like passive funds, they track an index, but they can be bought and sold throughout the day, rather than once a day as for funds.
What is passive management in leadership? ›
A passive leadership style concerns situations when a leader doesn't take on responsible tasks, doesn't want to get involved in problems and doesn't strive to solve them. A passive leader often doesn't know how to act or believes it's better to wait out the storm for the problems to fade away.
What is the difference between active and passive management? ›
The biggest difference between active investing and passive investing is that active investing involves a fund manager picking and choosing investments, whereas passive investing typically tracks an existing group of investments called an index.
Why is passive management better than active? ›
Because active investing is generally more expensive (you need to pay research analysts and portfolio managers, as well as additional costs due to more frequent trading), many active managers fail to beat the index after accounting for expenses—consequently, passive investing has often outperformed active because of ...
What is the other name of passive management? ›
Passive management is the contrast of active management, in which the manager(s) of a fund attempt to beat the market with different investment strategies and purchase/sell securities decisions. Passive management is also known as "passive policy," "passive spending," or "spending by index."
She asked me how that made any sense, and I had to break work down into two things — passive work, which is the nature of experience; and active work, which is the nature of using that experience to inform something tangible.
What does passive approach mean? ›
1 not active or not participating perceptibly in an activity, organization, etc. 2 unresisting and receptive to external forces; submissive. 3 not working or operating. 4 affected or acted upon by an external object or force.
What is passive management by exception? ›
In passive management by exception, the managers only get involved when certain standards are not met, when there is a need for further planning, or when corrective measures become necessary.
What are the kinds of passive strategy? ›
Types of Passive Funds
- Index Funds - Index Funds are mutual funds which replicate a particular index or a sector, in the respective proportions. ...
- Exchange Traded Funds (ETFs) - ETFs are pooled investments which are created to track the benchmark index or sector.
Index funds don't try to beat the market, or earn higher returns compared to market averages. Instead, these funds try to be the market — by buying stocks of every firm listed on a market index to match the performance of the index as a whole. Because of this, index funds are considered a passive management strategy.
What is the difference between active and passive managers? ›
Flexibility – because active managers, unlike passive ones, are not required to hold specific stocks or bonds. Hedging – the ability to use short sales, put options, and other strategies to insure against losses. Risk management – the ability to get out of specific holdings or market sectors when risks get too large.
What is the main difference between active and passive management? ›
Passive strategies involve minimal trading and research, resulting in lower transaction fees and management expenses. Active management, on the other hand, requires ongoing research, frequent trading, and managerial expertise, leading to higher costs.
