#passive management

As the name implies, these funds are designed to track the performance of a stock market index, the most commonly used in the UK being the FTSE All-Share Index.  Their success is measured not by whether they outperform their index, but by how closely they track it.

The natural approach is to hold shares in every company in the index, which is known as full replication.  In order to reduce running costs, funds can hold shares in a smaller number of companies, but need to be careful that this does not affect the accuracy of their tracking too much.  Some funds also use financial instruments.  Passive funds do not need to employ expert decision makers (as more conventional actively managed funds do) and therefore their annual management charges should be lower.

So which is better: active or passive management?  By definition, a passive fund will produce an average performance plus any gain from a lower management charge.  I tend to use the slightly lower risk passive approach.  However, if you feel that you can select a good active manager, please go ahead and back your judgement.

Certainly passive funds have been steadily increasing in popularity since American bank Wells Fargo introduced them to the UK in the 1970s.  [Older readers may remember Dale Robertson in the 1950s/60s TV series Tales of Wells Fargo which featured adventures in the early days of that bank.]

Finally here’s a philosophical thought.  If all investment were to be passive, there would be no one to influence share buying in any particular direction and little would change.  Stock markets will always need at least some active investors.

Why Amazon splits its nominal

Amazon (“Wide Moat”) has just announced plans for a 20-fold stock split, which, if approved by shareholders, would take effect June 6. This means that for every Amazon share you own, you will get 19 additional shares. This isn’t the first time Amazon has split its stock. The company completed a 2-to-1 split in 1998 and 1999, as well as a second split in 1999 of 3-to-1. Amazon is following in the…

Active and passive management

After the broad diversification and asset allocation decisions, you can define specific investment alternatives. However, before choosing your vehicles and investing, you must make a fundamental choice between active and passive management. Stock picking implies choosing a limited number of stocks and market timing means that you buy or sell at specific times in the hope of making a profit: This…

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, William Sharpe 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.

Suppose you have decided that you wish to invest in a fund which will produce a return broadly in line with the FTSE 100 Index.  You now need to select an investment manager who may offer an index tracking fund (aka as passive management), an actively managed fund or both.  How do you go about choosing?

Firstly you will not wish to increase your record keeping by investing with too many different fund managers.  In fact, in the case of stocks and shares ISAs, you are only allowed to use one provider in the current tax year.  Let us suppose that a manager you tend to favour has an annual management charge of 0.75% for their index tracking fund and 1.25% for their actively managed fund.  The question becomes whether their active management skills can over a period of time enhance their performance by more than 0.5% per annum (the difference between 0.75% and 1.25% per annum).

Now is the time to read the investment manager’s literature.  Under “Investment Objective” or something similar, you may read “The objective of this trust is to track the performance of the UK equity market as represented by the FTSE Index”.  The word “track” indicates that the fund is index tracking and hence not managed actively.  You will also need to know the annual management charge.

For an actively managed fund, you should see how their investment performance compares to the index (allowing for the adjustments for reinvested income and annual management charge) over each of the last (say) five years.  If you can’t find it easily in the literature, write and ask for it.  If you get an evasive answer, you know that they have underperformed!

If, however, their actively managed fund has performed well over the last five years as a whole, then it is probably a good idea to invest some or all of your money there.  Do keep investment performance under review in the future.

It is rarely the case that traditional document executive solutions are implemented in order to achieve cost savings, ROI, or process improvement.<\p>

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Investment pundits have often debated on what’s the best way to manage one’s investment portfolios. While some advocate active management, others prefer a more passive method. Each management type has its own set of pros and cons, but the main difference has to do with the target index. The index is a benchmark, usually a measure of the market’s performance determined by the performance of investments from a certain group of securities.

Image Source: portfoliomanagement101.com

Active management seeks to outperform the target index, and actively-managed funds are often run by professional investment managers. These managers use a variety of systems to capitalize from marketplace shortfalls (for example, managers may research company stock prices and compare them to the market). These methods are often heavy on analysis, and seeks to see a general picture of an investment’s future performance.

Image Source: investmentnews.com

Meanwhile,passive management is much simpler, as it only intends to match index returns. A passive management method is built around the perception of efficient markets, with little or no shortfalls. Passive funds usually use a sampling or replication method to track the target index. Because of its simplicity, passive management professionals often charge less than active managers.

Image Source: telegraph.co.uk