Passive management, also known as index fund management, is an investment strategy that involves the construction of a portfolio that would monitor returns of a specific market index as thoroughly as possible.
This approach also involves making long-term investments in particular securities and it is not affected by short-term market declines.
Index fund management does not require a management team and can be arranged as an exchange-traded fund (ETF), a mutual fund, or a unit investment trust.
Investors engaging in this strategy do not take uncompensated risk nor do they participate in market timing activities. They invest in asset classes, not specific stocks, sector funds, or individual country funds.
How it Works
Passive management, being a buy-and-hold strategy, involves purchasing a security with the aim of holding it for several years.
Investors believing in this method usually try to imitate performance of a seemingly particular index, which would need extensive research. Retail investors do this by acquiring one or more index funds.
An index fund can be executed by buying securities in the similar proportion as presented in the stock market index.
Unlike active management, which considers markets to be inefficient, passive management means holding that markets are highly competent.
Therefore, it is best to focus on asset allocation, fund construction, costs, tax efficiency, and creating a well-diversified portfolio that would lessen the impact of a certain risk.
Passive management will not be entirely passive unless the investor is buying shares of an index fund. The investor or the advisor has to actively decide the securities he/she wants to invest in.
It normally has to rely on fundamental studies of the company behind a security, including its long-term growth plan, its products’ quality, as well as its relationships with management when choosing whether to buy or sell.
Advantages of Passive Management
- Lowers expenses
- Reduces investment-related taxes
- Diversifies into index funds
- Maintains investment discipline
- Minimizes uncertainty of decision errors
- Style consistency
How to Build a Passive Portfolio
Invest in Index Funds
Given that index funds have a passive nature; it typically leads to performance that goes with broad market performance, instead of trying to outperform the market.
Create a Systematic Investment Plan (SIP)
Establishing a SIP makes investors’ mutual fund purchases automatic and excludes them from potential risks posed by market timing.
Use No-load Funds
No-load funds mean that they are free of sales charge. Investors do not need to pay additional fees, which helps them keep prices low, thus increasing their returns.
Use Core and Satellite Investing
The main goal for this is to minimize the risk through diversification while beating a standard benchmark for performance. A core and satellite portfolio is simply to hopefully obtain higher-than-average returns with lower-than-average risk for the investor.
Rebalance
Rebalancing will have the need of buying or selling shares if some or all of the mutual funds to put allocation percentages back into balance.
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