Passive management is a strategy where a fund
manager makes as few portfolio decisions as possible in order to
minimise transaction costs, including the incidence of capital gains
tax. One popular method is to mimic the performance of a 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. Today, there is a plethora
of market indexes in the world, and thousands of different index
funds tracking many of them.
Questions -- Why are index funds interesting? Why would it make
sense to sit there and do nothing? What is the empirical performance
of index funds?
The rationale behind indexing stems from three concepts of financial
- The efficient
markets hypothesis, which states 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
- 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.
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 US, 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
At the simplest, an index
fund is implemented by purchasing securities in the same proportion
as in the market
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. that seek to buy those particular shares that have
the best chance of good performance.
It is important to note also that closet indexing can occur where
a portfolio manager or institution will index some large part of
a portfolio (or otherwise enormously constrain the risk of underperforming
the index) whilst seeking to retain the higher fees that are earned
by active fund managers.