PASSIVE MANAGEMENT

The generally poor performance of traditional investment management approaches helped to motivate the development, in the late 1960s and the 1970s, of new theories of stock price behavior. The efficient market hypothesis and random walk theory, the products of much research, offered a reason for the meager returns reaped by traditional investment managers: Stock prices effectively reflect all information in an efficient manner, rendering stock price movements random and unpredictable. Efficiency and randomness provided the motivation for passive investment management; advances in computing power provided the means.

Passive management aims to construct portfolios that will match the risk-return profiles of underlying market benchmarks. The benchmark may be core equity (as proxied by the S&P 500 or other broad index) or a style subset (as proxied by a large-cap growth, large-cap value, or small-cap index). Given the quantitative tools at its disposal, passive management can fine-tune the stock selection and portfolio construction problems in order to deliver portfolios that mimic very closely both the returns and risks of their chosen benchmarks.

Passive portfolios, unlike traditional portfolios, are disciplined. Any tendencies for passive managers to succumb to cognitive biases will be held in check by the exigencies of their stated goals—tracking the performances of their underlying benchmarks. Their success in this endeavor also means that the resulting portfolios will have integrity. A passive value portfolio will behave like its underlying selection universe, and a combination of passive style portfolios in market-like weights can be expected to offer a return close to the market's return at a risk level close to the market's. As the trading required to keep portfolios in line with underlying indexes is less than that required to beat the indexes, transaction costs for passive management are lower than those incurred by active investment approaches. As much of the stock selection and portfolio construction problem can be relegated to fast-acting computers, the management fees for passive management are also modest. For the same reason, the number of securities that can be covered by any given passive manager is virtually unlimited; all the stocks in the selection universe can be considered for portfolio inclusion.

Unlike traditional management, then, passive management offers great breadth. Breadth in this case doesn't count for much, however, because passive management is essentially insightless. Built on the premise that markets are efficient, hence market prices are random and unpredictable, passive management does not attempt to pursue or offer any return over the return on the relevant benchmark. Rather, its appeal lies in its ability to deliver the asset class return or to deliver the return of a style subset of the asset class. In practice, of course, trading costs and management fees, however modest, subtract from this performance.

An investor in pursuit of above-market returns may nevertheless be able to exploit passive management approaches via style subset selection and style rotation. That is, an investor who believes value stocks will outperform the overall market can choose to overweight a passive value portfolio in expectation of earning above-market (but not above-benchmark) returns. An investor with foresight into style performance can choose to rotate investments across different passive style portfolios as underlying economic and market conditions change.