Passive management (also called passive investing) is an investing strategy that tracks a market-weighted index or portfolio. 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.Burton G. Malkiel, A Random Walk Down Wall Street, W. W. Norton, 1996, There has been a substantial increase in passive investing over the last twenty years.
The most popular method is to mimic the performance of an externally specified index by buying an index fund. By tracking an index, an investment portfolio typically gets good diversification, low turnover (good for keeping down internal transaction costs), and low management fees. With low fees, an investor in such a fund would have higher returns than a similar fund with similar investments but higher management fees and/or turnover/transaction costs.William F. Sharpe, Indexed Investing: A Prosaic Way to Beat the Average Investor. May 1, 2002. Retrieved May 20, 2010.
The bulk of money in passive index funds are invested with the three passive asset managers: BlackRock, Vanguard and State Street. A major shift from assets to passive investments has taken place since 2008. Hidden power of the Big Three? Passive index funds, re-concentration of corporate ownership, and new financial risk | Jan Fichtner, Eelke M. Heemskerk and Javier Garcia-Bernardo | Business and Politics 2017; 19(2): 298–326 | Conclusion
Passively managed funds consistently outperform actively managed funds. More than three-quarters of active mutual fund managers are falling behind the S&P 500 and the Dow Jones Industrial Average. The S&P Indices versus Active (SPIVA) scorecard, which tracks the performance of actively managed funds against their respective category benchmarks, showed that 79% of fund managers underperformed the S&P in 2021. It reflects an 86% jump over the past 10 years. In general, actively managed funds have failed to survive and beat their benchmarks, especially over longer time horizons; only 25% of all active funds topped the average of their passive rivals over the 10-year period ended June 2021. Investors, academicians, and authors such as Warren Buffett, John C. Bogle, Jack Brennan, Paul Samuelson, Burton Malkiel, David Swensen, Benjamin Graham, Gene Fama, William J. Bernstein, and Andrew Tobias have long been strong proponents of passive investing.
Siegel, J.J. (2019). Climbing Mount Everest: Paul Samuelson on Financial Theory and Practice. In: Cord, R., Anderson, R., Barnett, W. (eds) Paul Samuelson. Remaking Economics: Eminent Post-War Economists. Palgrave Macmillan, London.
History The first US market indexes date to the 1800s. The Dow Jones Transportation Average was established in 1884 with eleven stocks, mostly railroads. The Dow Jones Industrial Average was created in 1896 with 12 stocks in industrial manufacturing, energy and related industries. Both are still in use with modifications, but the Industrial Average, commonly called "The Dow" or "Dow Jones", is more prominent and came to be regarded as an important measure for the American economy as a whole. Other influential US indexes include the S&P 500 (1957), a curated list of 500 stocks selected by committee, and the Russell 1000 Index (1984), which tracks the largest 1,000 stocks by market capitalization. The FTSE 100 (1984) represents the largest publicly traded in the UK, while the MSCI World index (1969) tracks stock markets of the entire developed world.
Unit investment trusts (UITs) are a type of U.S. investment vehicle that prohibits or severely restricts changes to the assets held in the trust. One such UIT is the Voya Corporate Leaders Trust (LEXCX), which as of 2019 was the oldest passively managed investment fund still in existence in the United States according to John Rekenthaler of Morningstar, Inc.John Rekenthaler (2019-12-24). The Strange and Happy Tale of Voya Corporate Leaders Trust: A fund that shouldn’t succeed, but does. Morningstar.com, accessed 02 November 2020 Founded in 1935 as the Lexington Corporate Leaders Trust, LEXCX initially held 30 stocks, closely modeled on the Dow Industrials. LEXCX prohibited the purchase of new assets apart from those related directly to the original 30 (as with spin-offs or Mergers and acquisitions) and prohibited the sale of assets except when a stock eliminated dividends or was at risk of de-listing from the stock exchange. Unlike later index funds that are usually cap weighted, with greater proportional holdings in larger companies, LEXCX is share weighted: "holding the same number of shares in each company regardless of price."James P. O'Shaughnessy (1997). What Works on Wall Street: A Guide to the Best-Performing Investment Strategies of All Time, NY: McGraw-Hill, 0-07-047985-2, p. 9 An evaluation by U.S. News & World Report found the fund was passively managed: "for all intents and purposes, this fund's portfolio is on autopilot."Voya Corporate Leaders Trust Fund: Overview. U.S. News & World Report. Accessed 2020-11-02
The theory underlying passive management, the efficient-market hypothesis, was developed at the Chicago Graduate School of Business in the 1960s.Justin Fox (2009) The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street. HarperCollins
During this same period, researchers first began to discuss the concept of an "unmanaged investment company". In 1969, Arthur Lipper III became the first to try to turn theory into practice by petitioning the Securities and Exchange Commission to create a fund tracking the 30 stocks Dow Industrial Average. According to Lipper, the SEC did not respond. The first index funds were launched in the early 1970s, by American National Bank in Chicago, Batterymarch, and Wells Fargo; they were available only to large pension plans. The first index fund for individual investors was launched in 1976. The Vanguard First Index Investment Fund (now the Vanguard 500 Index Fund) was the brainchild of John (Jack) Bogle.
Investment in passive strategies
Research conducted by the World Pensions Council (WPC) suggests that 15% to 20% of overall assets held by large pension funds and national social security funds are invested in various forms of passive funds- as opposed to the more traditional actively managed mandates which still constitute the largest share of institutional investments. The proportion invested in passive funds varies widely across jurisdictions and fund type.
The relative appeal of passive funds such as ETFs and other index-replicating investment vehicles has grown rapidly for various reasons ranging from disappointment with underperforming actively managed mandates to the broader tendency towards cost reduction across public services and social benefits that followed the 2008-2012 Great Recession. Public-sector pensions and national reserve funds have been among the early adopters of passive management strategies.
At the Federal Reserve Bank of St. Louis, YiLi Chien, Senior Economist wrote about return-chasing behavior. The average equity mutual fund investor tends to buy MUTUAL FUNDS with high past returns and sell otherwise. Buying MUTUAL FUNDS with high returns is called a "return-chasing behavior". Equity mutual fund flows have a positive correlation with past performance, with a return-flow correlation coefficient of 0.49. Stock market returns are almost unpredictable in the short term. Stock market returns tend to go back to the long-term average. The tendency to buy MUTUAL FUNDS with high returns and sell those with low returns can reduce profit.copied from the wikipedia article Market timing copied from wikipedia article Buy & Hold
Unsophisticated short-term investors sell passive ETFs during extreme market times. Passive funds affect the price of stocks. Todorov, Karamfil, Passive Funds Actively Affect Prices: Evidence from the Largest ETF Markets (November 14, 2019). Available at SSRN: https://ssrn.com/abstract=3504016 or http://dx.doi.org/10.2139/ssrn.3504016
Rationale for passive investing The concept of passive management is counterintuitive to many investors. The rationale behind indexing stems from the following concepts of financial economics:
In the long term, the average investor will have an average before-costs performance equal to the market average. Therefore, the average investor will benefit more from reducing investment costs than from trying to beat the average, and passive investments generally charge lower fees than actively-managed investments. This argument is commonly known as William Sharpe's zero-sum game theory. The efficient-market hypothesis postulates that equilibrium market prices fully reflect all available information, or to the extent there is some information not reflected, there is nothing that can be done to exploit that fact. It is widely interpreted as suggesting that it is impossible to systematically "beat the market" through active management, although this is not a correct interpretation of the hypothesis in its weak form. Stronger forms of the hypothesis are controversial, and there is some debatable evidence against it in its weak form too. For further information see behavioural finance. 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.Agency Theory, Agency Theory Forum. Retrieved May 20, 2010.
Advocates for passive management argue that performance results provide support for Sharpe's zero-sum game theory. There are two prominent reports that compare the performance of index funds with the performance of actively-managed funds, the SPIVA (S&P Indexes Versus Active Funds) report and the Morningstar Active-Passive Barometer.
Concerns about passive investing Criticism has been leveled at passive investment by investors like Howard MarksHoward Marks (2018), Investing Without People, Oaktree.com, retrieved 2020-12-28 Carl Icahn, Michael Burry and Jeffrey GundlachCarmen Reinicke (Aug 29, 2019). 'Big Short' investor Michael Burry is calling passive investment a 'bubble.' He's not the only finance luminary sounding the alarm. Business Insider, retrieved 2020-12-25 who argue that asset bubbles can be considered a byproduct of the increasing popularity of passive investing. John C. Bogle of The Vanguard Group, while a staunch advocate for passive investing overall, also argued in 2018 that the growth in passive management firms would soon result in a concentration of over half of American stock ownership, and associated proxy voting power, among three large firms (Vanguard, State Street Global Advisors and BlackRock). Bogle stated: "I do not believe such a concentration would serve the national interest".Financial Management Guide
In 2017, Robert Shiller, a Nobel Prize winning economist at Yale University, stated passive index funds are a "chaotic system" and "kind of pseudoscience" due to what he described as an over-reliance on computer models and a neglect of the businesses whose stocks make up index funds.Stephanie Landman (2017-10-14) Passive investing is a ‘chaotic system’ that could be dangerous, warns Robert Shiller. CNBC.com, retrieved 2020-12-28