Passive Management: What it is, How it Works

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."

Understanding 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, the University of Chicago's professor of economics, Eugene Fama, conducted extensive research on stock price patterns, which led to his development of the Efficient Capital 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 based on 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.

William F. 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 the 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.

Ongoing 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 2021 alone, $1.2 trillion poured into passive U.S. equity funds, according to fund tracker Morningstar. Conversely, as of April 2002, over the last five years $86.4 billion fled actively managed funds. However, much of the influx to passive funds flowed to taxable and municipal bond funds.