Passive management

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 1869 with 12 stocks in industrial manufacturing, energy and related industries.[6] 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 Standard & Poor's 500 (1957), a curated list of 500 stocks selected by committee, and the Russell 1000 (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..[7] Founded in 1935 as the Lexington Corporate Leaders Trust, LEXCX initially held 30 stocks, closely modeled on the Dow Industrials, and prohibited the purchase of new asests apart from those related directly to the original 30 (as with mergers, spin-offs or acquisitions). 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."[8] An evaluation by US News & World Report found the fund was passively managed: "for all intents and purposes, this fund's portfolio is on autopilot."[9]

The modern concept of passive management developed in the late 1960s and early 1970s.[10] Academic researchers in finance and investing, particularly Eugene Fama and colleagues at the University of Chicago, were able to make several critical discoveries. First, determining average annual growth rates for the American stock market over long periods. Second, proposing that most active management was unable to consistently outperform market averages. Third, demonstrating how management fees and trading commissions could be a significant drain on profits.

From this research, the idea of offering low-fee index funds gained popularity. Economist and Nobel Laureate Paul Samuelson testified before Congress in 1967 on the growing popularity of mutual fund companies. He cited research indicating a randomly selected portfolio of 20 stocks was likely to perform as well as, if not better than, the typical actively managed mutual fund.[10] Furthermore, Samuelson noted it was usually more profitable to invest in a mutual fund company rather than in their funds, and argued most funds demanded high fees for investing advice of dubious value. Samuelson urged the financial industry to offer index funds to the general public and in a later article wrote how brokerages "should set up an in-house portfolio that tracks the S&P 500 Index – if only for the purpose of setting up a naive model against which their in-house gunslingers can measure their prowess."[11]

In 1969, A. Michael Lipper III, later of Lipper Analytical Services, petitioned the Securities and Exchange Commission to create a fund tracking the 30 stocks Dow Industrial Average. His request was ignored.[10] Batterymarch Financial Management, a small Boston firm, began promoting an index fund in 1971 but didn't have paying customers until 1974.[10] Larger and more successful index funds were pioneered by John "Mac" McQuown and Rex Sinquefield .[10] [12] Starting in 1971, McQuown managed part of Samsonite's multi-million pension fund for Wells Fargo's San Francisco office as the head of Wells Fargo Investment Advisors. McQuown initially attempted an equal-weight index of all stocks traded on the New York Stock Exchange, but this proved too difficult to manage and he eventually turned to a cap-weighted S&P 500 index. McQuown's fund was ultimately sold to Barclays and then to BlackRock. Sinquefield, a University of Chicago graduate, opened a cap-weighted S&P 500 fund in 1973 while employed at the American National Bank of Chicago. After seven years, Sinquefield's fund had $7 billion under management. McQuown and Sinquefield both went on to work at Dimensional Fund Advisors (DFA).

Vanguard created an S&P 500 index in 1976, with Jack Bogle being inspired by Samuelson's writings on the subject.

In the 1970s, DFA and Vanguard were two of the earliest American investing companies to focus on passive management of investments, though with different strategies.

The concept of passive management is counterintuitive to many investors.[3][13] The rationale behind indexing stems from the following concepts of financial economics:[3]

1. 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.[1][14]
2. 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,[15] 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.
3. 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.[16][17]
4. 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 some very strong assumptions, a fund indexed to "the market" is the only fund investors need to obtain the highest risk-adjusted return possible.[3] The CAPM has been rejected by empirical tests.
5. The passive investment strategy (buy-and-hold) is supported when there are both high levels of inflation and GDP growth.[18]

The bull market of the 1990s helped spur the 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.[3][19]

In the United States, 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. This holds true when comparing both, mutual fund and the passive benchmark with the money market account, but changes by taking differential returns into account.[3][20]

Some active managers may beat the index in particular years, or even consistently over a series of years.[21] Nevertheless, Jack Bogle noted the retail investor still has the problem of discerning how much of the out-performance was due to skill rather than luck, and which managers will do well in the future.[22]

Investment funds run by investment managers who closely mirror the index in their managed portfolios and offer little "added value" as managers whilst charging fees for active management are called "closet trackers" or "closet indexers" that is they do not in truth actively manage the fund but furtively mirror the index. The concept of active share, a measure how much a fund deviates from its benchmark, has been identified as important in funds that consistently out-perform averages.[23]

The first step to implementing an index-based passive investment strategy is choosing a rules-based, transparent, and investable index consistent with the investment strategy's desired market exposure. Investment strategies are defined by their objectives and constraints, which are stated in their Investment Policy Statements. For equity passive investment strategies, the desired market exposures could vary by equity market segment (broad market vs. industry sectors, domestic vs. international), by style (value, growth, blend/core), or by other factors (high or low momentum, low volatility, quality).[24]

Index rules could include the frequency at which index constituents are re-balanced, and criteria for including such constituents. These rules should be objective, consistent and predictable. Index transparency means that index constituents and rules are clearly disclosed, which ensures that investors can replicate the index. Index investability means that the index performance can be reasonably replicated by investing in the market. In the simplest case, investability means that all constituents of an index can be purchased on a public exchange.[25]

Once an index has been chosen, an index fund can be implemented through various methods, financial instruments, and combinations thereof.

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.[38] The proportion invested in passive funds varies widely across jurisdictions and fund type.[38][39]

The relative appeal of passive funds such as ETFs and other index-replicating investment vehicles has grown rapidly [40] for various reasons ranging from disappointment with underperforming actively managed mandates [38] to the broader tendency towards cost reduction across public services and social benefits that followed the 2008-2012 Great Recession.[41] Public-sector pensions and national reserve funds have been among the early adopters of passive management strategies.[39][41]

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.[42]

Unsophisticated short-term investors sell passive ETFs during extreme market times. Passive funds affect the price of stocks.[43]

Active Managers do not practice "Buy and Hold." At least 80% of active managers fell below their respective benchmarks across all domestic equity categories over 15 years. All domestic funds had a 44% survivor rate of over 15 year, so a Survivorship Bias Correction is made. Survival is a measure that represents the proportion of funds that exist at the beginning of the period and remain active at the end of the time period.[44]

Criticism has been leveled at passive investment by investors like Howard Marks[45] Carl Icahn, Michael Burry and Jeffrey Gundlach[46] 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".[46]

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. [47]

According to researchers with the Federal Reserve who published their findings in 2020, the growing popularity of passive investing has increased some risks for investors and the economy generally, but reduced other risks. "Some passive strategies amplify market volatility, and the shift [towards passive investing] has increased industry concentration, but it has diminished some liquidity and redemption risks."[48]

In response, defenders of passive investing argue that some claims against the strategy are incorrect, and that other claims are partially accurate but overstated.[49]

• Investment management
• Active management
• Exchange-traded fund
• Buy and hold
• Index fund
• Enhanced indexing
• Relative return
• Value investing

• Burton G. Malkiel, A Random Walk Down Wall Street, W. W. Norton, 1996, ISBN 0-393-03888-2
• John Bogle, Bogle on Mutual Funds: New Perspectives for the Intelligent Investor, Dell, 1994, ISBN 0-440-50682-4
• M. Nicolas J. Firzli, "Passive Play: Disenchanted Asset Owners Going Low-Cost as the ‘Age of Austerity’ Lingers", Revue Analyse Financière 54 (2015): 68-70.
• Mark T. Hebner, Index Funds: The 12-Step Program for Active Investors, IFA Publishing, 2007, ISBN 0-9768023-0-9

• The Active vs Passive - unresolved issues.
• The Future of Investment Management
• Lazy portfolios on Bogleheads.org