What is 'Passive Management'

Passive management is a style of management associated with mutual and exchange-traded funds (ETF) where a fund's portfolio mirrors a market index. Passive management is the opposite of active management in which a fund's manager(s) attempt to beat the market with various investing strategies and buying/selling decisions of a portfolio's securities. Passive management is also referred to as "passive strategy," "passive investing" or " index investing."

BREAKING DOWN 'Passive Management'

Followers of passive management believe in the efficient market hypothesis. It states that at all times markets incorporate and reflect all information, rendering individual stock picking futile. As a result, the best investing strategy is to invest in index funds, which have historically outperformed the majority of actively managed funds.

The Research Behind Passive Management

In the 1960s, University of Chicago professor of economics, Eugene Fama, conducted extensive research on stock price patterns, which led to his development of the Efficient Market Hypothesis (EMH). The EMH maintains that market prices fully reflect all available information and expectations, so current stock prices are the best approximation of a company’s intrinsic value. Attempts to systematically identify and exploit stocks that are mispriced on the basis of information typically fail because stock price movements are largely random and are primarily driven by unforeseen events. Although mispricing can occur, there is no predictable pattern for their occurrence that results in consistent outperformance. The efficient markets hypothesis implies that no active investor will consistently beat the market over long periods of time, except by chance, which means active management strategies using stock selection and market timing cannot consistently add value enough to outperform passive management strategies.

Sharpe concluded that, as a whole, active fund managers underperform passive fund managers, not because there is anything inherently wrong in their financial strategies, but simply because of the laws of arithmetic. For active managers to outperform the market, they have to achieve a return that can overcome their fund expenses, which are much higher than passive funds due to higher management fees, higher trading costs and higher turnover. This is consistent with Sharpe’s research which shows that, as a group, active managers underperform the market by an amount equivalent to their average fees and expenses.

When a passive management strategy is employed, there is no need to expend time or resources on stock selection or market timing. Because of the short-term randomness of returns, investors would be better served through a passive, structured portfolio based on asset class diversification to manage uncertainty and position the portfolios for long-term growth in the capital markets.

Recent Rush to Passive Management

Due to poor returns of active management and the recommendation of influential financiers like Warren Buffett, investor cash has flooded into passive management in recent years. In 2017 alone, $692 billion poured into index funds, with U.S. equity and international equity funds being the most popular. Conversely, $7 billion fled actively managed funds. The amount was the lowest in two years, signifying a stanching of the blood-letting in the category. However, most of the influx flowed to taxable bond funds. Excluding this type, active funds would have lost $185.8 billion for the year. 

RELATED TERMS
  1. Passive Activity Loss Rules

    Passive activity loss rules are a set of IRS rules that prohibits ...
  2. Active Management

    Active management consists of a human overseer or group making ...
  3. Passive Activity

    Passive activity is activity that a taxpayer did not materially ...
  4. Passive Loss

    A passive loss is a financial loss within an investment in any ...
  5. Active Index Fund

    Active index funds track an index fund with an additional layer ...
  6. Actively Managed ETF

    An active managed ETF is a form of exchange-traded fund that ...
Related Articles
  1. Investing

    How to Determine the Best Investment Strategy for You

    Before choosing passive or active investing for your portfolio, understand the differences.
  2. Investing

    4 Reasons Most ETFs are Passively Managed

    Find out the top four reasons most ETFs are passively managed, including the benefits of lower costs, greater tax efficiency and low asset turnover.
  3. Investing

    Why Its Sunset for Wall Street's Stock Pickers (JNS)

    Investors are abandoning actively managed mutual funds, hedge funds, ETFs and other vehicles at an accelerating rate in favor of passive funds
  4. Investing

    Is Active Management Making a Comeback?

    The performance of actively-managed funds is starting to surpass their passive rivals. Here's why.
  5. Investing

    Stock Pickers Are Shining Amid Market Turmoil

    Active investment managers performed better than passive funds in the recent stock market downturn.
  6. Financial Advisor

    Passive vs. Active Management: Which is Best?

    Portfolio performance is as much about picking asset classes as picking stocks. Timing the market, however, is something else altogether.
  7. Investing

    Smart Beta vs. Active Management: Which is Better? (BLK, SCHB)

    Learn how smart beta funds combine the advantages of both active and passive management by tracking customized indexes without capitalization weighting.
  8. Investing

    Use Passive Investing to Protect Against Volatility

    Passive investment strategies are the best for protecting your assets during volatility.
  9. Investing

    Buy-And-Hold Investing Vs. Market Timing

    If volatility and emotion are removed, passive, long-term investing comes out on top.
RELATED FAQS
  1. Passive vs Active Portfolio Management

    Understand the difference between active portfolio management and passive portfolio management, and how each strategy benefits ... Read Answer >>
  2. What are the disadvantages of an index fund over an actively managed fund?

    Read the advantages an actively managed fund has over its more staid compatriot, the indexed fund, and make your own decision ... Read Answer >>
  3. Should I invest in ETFs or index funds?

    Learn the advantages to investing in exchange-traded funds, or ETFs, and index funds, and decide whether to include them ... Read Answer >>
Trading Center