Passive Management

What Is Passive Management?

Passive Management refers to an investment strategy whereby a particular exchange-traded fund or index fund's portfolio tracks the performance of a benchmark or market index. Since such approach functions on the efficient market hypothesis theory, the fund manager cannot control the entry or exit of underlying securities.

The primary aim of the passive strategy is to yield high returns in the long run without making an effort to select securities that align with the portfolio objective or constantly review the portfolio for including or removing the stocks. Moreover, a passively managed fund is comparatively cheaper for the investors and involves lower risk than active funds.

• Passive management is an investing strategy whereby the portfolio manager creates a fund that copies the performance of a market index while holding the same securities, usually in the identical composition as that of the latter.
• Such a strategy is commonly employed for mutual funds, index funds, and exchange-traded funds.
• It functions on the ideology that the markets are efficient, and no investing strategy can generate exceptional returns.
• A passively managed fund doesn't require constant monitoring, is cost-effective, tax-efficient, transparent, has long-term growth potential, and diversifies across a broad asset class or sector.

Passive Management Explained

Passive management is a fund management strategy that emphasizes the style of investing in the same securities and in the same composition as that of a market index that it is following. The idea is to generate identical returns to that of the benchmark. It usually applies to mutual funds, index funds, and exchange-traded funds (ETFs). Moreover, passive funds have shown exceptional performance in the long run compared to active funds. Indeed, these are low-cost funds that involve less risk and tax implications.

In 1932, Alfredo Cowles spotted that the active fund managers were underperforming, and the US witnessed a shift in investors' preference from active management towards passive investing. They found the latter to be much more beneficial regarding cost, market efficiency principle, returns skewness, and a professional approach. It was the era when passive strategy became popular across the US and Europe. However, a prominent reason behind the poorly performing active managers was the industry's institutionalization.

Passive investing in US mutual funds and ETFs has, for the first time, surpassed actively managed counterparts in assets, totaling $13.3 trillion compared to $13.2 trillion. The most significant contribution was of massive inflows into ETFs, with passive funds attracting $529 billion in 2023 while active funds lost $450 billion. Vanguard's introduction of the world's first index mutual fund in 1976 initiated the rise of passive strategies. Despite sporadic outperformance, active managers have generally lagged.

The popularity of ETFs, which trade like stocks, has bolstered the growth of passive management. Active ETFs are also gaining traction but remain a smaller segment of the market. This trend reflects a preference for replicating benchmarks rather than striving to outperform them. This leads to a shift towards more cost-effective passive investment options.

Examples

To understand how passive management works, let us take a look at some examples:

Example #1

Suppose ABC fund is a passive management mutual fund that copies the performance of the PQR Index. If the composition of the PQR Index is as follows:

Security	Weight
Stock X	20%
Stock Y	17%
Stock Z	33%
Bond P	30%

Then, the ABC fund will have the same underlying assets and be of the same composition. Say if the PQR Index generates 27% returns over 5 years. Then ABC fund will also yield a return of 27% in that span.

Example #2

One of the popular passively managed funds is Fidelity Index World Fund P Accumulation. This is a Global Large Cap Blend Equity that mimics the performance of its benchmark, MSCI World (Net Total Return) Index. It aims to enhance the investors' portfolio value when they remain invested for five or more years. However, it has avoided investing in certain companies that are included in the benchmark or the same composition as that of the index fund due to specific practical reasons.

The performance of this fund and the trailing returns over the last five years are visible in the graphs below: 

Advantages And Disadvantages

Passive investing is often considered to copy a benchmark, a curated securities portfolio. However, such a fund management strategy has various pros and cons, as discussed below:

Advantages

1. Minimal Cost: Passive investing doesn't require constant tracking of underlying securities' performance. Therefore, it involves low management fees, making it cost-efficient for investors.
2. Tax Efficiency: There is no frequent buying or selling, and the investors couldn't make substantial capital gains in the short run. Therefore, such funds don't involve considerable tax liabilities.
3. Diversification: By investing in passive funds, the investors can spread the risk across a broader market segment, asset class, or sector.
4. Long-Term Approach: Passive funds are known to yield high returns in the long run. This is because the market index or benchmark eventually grows over the period, yielding significant capital gain.
5. Transparency: Investors are aware of the securities where their money is invested since the inclusions are the same as those of the relevant market index.
6. Affordability: Passively managed funds, like mutual funds and ETFs, require a meager minimum investment. This makes them affordable and accessible for a small investor.
7. Consistency and Stability: Such funds often demonstrate consistent performance and are less affected by market volatility.

Disadvantages

1. Limited Flexibility: Passively managed funds are rigid. One cannot customize their asset holding with the changing market conditions or individual stock performance.
2. Inability to Manage Risk: Such a strategy doesn't account for risk management measures. This is because it replicates the market index straightaway and has no control over the individual security in the portfolio.
3. Cannot Outperform: Compared to active funds, passive funds may not offer the desired level of returns. They can provide either similar or lower returns than their benchmark.

Passive Management vs Active Management

Passive and active management are the two opposite poles of fund management. Given below are the various dissimilarities between these two investment strategies:

Basis	Passive Management	Active Management
Definition	It is an investment strategy that aims to allocate funds to the same securities as in its benchmark index to mimic the returns of the latter.	It is an investment strategy that allows the portfolio manager to choose the fund allocation and securities based on the investor's objective.
Strategy	Matching the performance of a benchmark or market index while emphasizing index investing, buy-and-hold strategy, and strategic asset allocation	Outperforming the benchmark index by picking selective securities and timing the market through technical and fundamental analysis
Market Assumption	Markets are efficient, and there cannot be any scope for exceptional returns.	Markets are not always efficient, and there can be chances of making superior profits through pricing inefficiencies.
Selection of Securities	The securities in such a fund's portfolio are the same as in the index it tracks	A portfolio manager chooses the assets in the portfolio.
Returns	Provides high returns in the long run	Offers impressive returns, sometimes better than the benchmark returns
Risk Involved	It involves less risk since the investment is diversified across a broader market index, which is less influenced by market fluctuations.	It involves high risk but enables fund managers to respond to market fluctuations or conditions quickly.
Cost	Minimal fees	High trading costs such as management fees
Flexibility	It involves very little flexibility as it merely follows a market index	Greater flexibility in choosing the securities in a portfolio
Transparency	The investors have a clear idea of the securities they are invested in.	There is less transparency since the fund manager can change the portfolio composition based on market conditions and the investor's objective.
Tax-Related Benefit	It is tax efficient since it doesn't provide high short-term capital gains	It is efficient for tax management as the fund manager can offset the losses from poor-performing securities against the profits of the ones with high returns.

Frequently Asked Questions (FAQs)

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