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 1896 with 12 stocks in industrial manufacturing, energy and related industries.[9] 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 S&P 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.[10] Founded in 1935 as the Lexington Corporate Leaders Trust, LEXCX initially held 30 stocks, closely modeled on the Dow Industrials. LEXCX prohibited the purchase of new assets apart from those related directly to the original 30 (as with spin-offs or Mergers and acquisitions) and prohibited the sale of assets except when a stock eliminated dividends or was at risk of de-listing from the stock exchange. 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."[11] An evaluation by U.S. News & World Report found the fund was passively managed: "for all intents and purposes, this fund's portfolio is on autopilot."[12]

The theory underlying passive management, the efficient-market hypothesis, was developed at the Chicago Graduate School of Business in the 1960s.[13]

During this same period, researchers first began to discuss the concept of an "unmanaged investment company."[14] In 1969, Arthur Lipper III became the first to try to turn theory into practice by petitioning the Securities and Exchange Commission to create a fund tracking the 30 stocks Dow Industrial Average. According to Lipper, the SEC did not respond.[13] The first index funds were launched in the early 1970s, by American National Bank in Chicago, Batterymarch, and Wells Fargo; they were available only to large pension plans.[13] The first index fund for individual investors was launched in 1976. The Vanguard First Index Investment Fund (now the Vanguard 500 Index Fund) was the brainchild of John (Jack) Bogle.[15]

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.[16] The proportion invested in passive funds varies widely across jurisdictions and fund type.[16][17]

The relative appeal of passive funds such as ETFs and other index-replicating investment vehicles has grown rapidly [18] for various reasons ranging from disappointment with underperforming actively managed mandates [16] to the broader tendency towards cost reduction across public services and social benefits that followed the 2008-2012 Great Recession.[19] Public-sector pensions and national reserve funds have been among the early adopters of passive management strategies.[17][19]

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.[20]

Unsophisticated short-term investors sell passive ETFs during extreme market times. Passive funds affect the price of stocks.[21]

The concept of passive management is counterintuitive to many investors.[3] 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, and passive investments generally charge lower fees than actively-managed investments. This argument is commonly known as William Sharpe's zero-sum game theory.[1]
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,[22] 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.[23][24]

Advocates for passive management argue that performance results provide support for Sharpe's zero-sum game theory.[1] There are two prominent reports that compare the performance of index funds with the performance of actively-managed funds, the SPIVA (S&P Indexes Versus Active Funds) report[25] and the Morningstar Active-Passive Barometer.[26]

Criticism has been leveled at passive investment by investors like Howard Marks[27] Carl Icahn, Michael Burry and Jeffrey Gundlach[28] 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".[28]

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.[29]

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."[30]

Passive investing may contribute to shareholder apathy, whereby investors are less engaged in the corporate governance process.

In response, defenders of passive investing argue that some claims against the strategy are incorrect, and that other claims are partially accurate but overstated.[31][32]

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).[33]

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.[34]

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

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

• 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