Passive Management

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Meaning and definition of passive management

Passive management refers to a style of management related to mutual and exchange traded funds wherein a fund’s portfolio reflects the market index. Passive management is the converse of active management which includes attempt by a fund’s manager to beat the market with different investing strategies and selling/buying decisions of securities of a portfolio. Passive management is also referred as ‘passive strategy’, ‘index investing’, and ‘passive investing.’

As explained by Investopedia, followers of passive management hold strong belief in the efficient market hypothesis. It mentions that at all times, markets include and mirror all info, exposé individual stock picking ineffectual. As a consequence, the finest investing strategy is to invest in index funds for these have always outperformed a large number of actively managed funds.

Raison d'être

The passive management concept is counterintuitive for many investors. The raison d’être underlying indexing arise from five financial economic concepts:

1. In the long run, the average investor will encompass an average before-cost performance equivalent to the market average. Thus, the average investor will benefit more from dipping investment costs rather than trying to hit the average.

2. The efficient market hypothesis proposes that balanced market prices reveal all available info, or to the extent there is some unrevealed info, there is nothing you can do to exploit the fact. It is generally interpreted as suggesting that it is not possible to analytically beat the market through active management, even though this is not an accurate interpretation of the hypothesis in its weak form.

3. The principal-agent problem, which involves investor (the principal) allocating money to a portfolio manager (the agent), needs to give proper incentives to the manager to run the portfolio according to the risk/return appetite of the investor. And should also monitor the performance of the manager.

4. The local elasticity of the market, while generally theorized not to be conducive to any specific investment strategy, can actually be favorable in numerous cases to a stable strategy, setting passive management away from its counterparts which are more change-prone.

5. The CAPM portfolio and the related portfolio separation theorems, which state that., in equilibrium, all investors will hold an amalgamation of a riskless asset and market portfolio. This implies, under favorable conditions, a fund indexed to “the market” is the only fund needed by the investors. 

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