Passive management

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.

Rationale

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 economics:

1. 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.
2. 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.
3. 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 after-tax returns.

Implementation

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.