What Does Passive Management Actually Mean?

Last Updated May 10, 2011 11:38 AM EDT

There are many misconceptions about what passive management really means, as the term passive doesn't provide an accurate description of the strategy. So, I thought it worthwhile to describe the differences between active management and passive management. Let's begin by defining the two conflicting theories.

Active Management Active management holds that the markets are inefficient. Thus, smart people working diligently can discover which stocks are undervalued and buy them. And, they can discover which stocks are overvalued and avoid them (or even sell them short). That's the art of stock selection.

Active investors also believe they can anticipate when the bull is going to enter the arena and buy stocks ahead of the rally (or avoid stocks before the bear emerges from hibernation). This is the art of market timing. Stock selection and market timing combine to form active management.

Passive Management Passive management means believing that markets are highly efficient. In turn, this means the market price of a security is the best estimate of the right price, and efforts to outperform are unlikely to prove productive after the expenses of the efforts. Thus, the winning strategy is to focus on:
  • Asset allocation, which defines the amount and types of risk you take
  • Fund construction
  • Costs
  • Tax efficiency
  • Building globally diversified portfolios that minimize (if not eliminate) the taking of idiosyncratic, uncompensated risks
Active management proponents fall into two categories:
  • Do-it-yourselfers who buy and sell individual stocks and/or shift their asset allocations based on their views about the overall market, sectors, countries or regions
  • Delegators who hire advisors or money managers to engage in these activities for them
Passive investors, on the other hand, develop an investment policy statement (IPS) with an asset allocation plan based on assumptions about their unique ability, willingness and need to take risk. The plan defines the target amount they will invest in each asset class. It also provides minimum and maximum tolerance ranges for rebalancing purposes. For example, the target for stocks might be 60 percent, and the minimum and maximums would be 55 and 65 percent. They also automatically invest cash whenever it is available, using cash available to rebalance.

It's important to note that active investors can also do these things. However, they use active strategies to implement their IPS. So, if you buy and hold an actively managed fund, you're not a passive investor. You're being passive, but the manager is active. For you to be passive, both you and your investments must be passive.

One thing that distinguishes passive management from active management is that passive investors don't take uncompensated risks. They invest in asset classes, not individual stocks, sector funds or individual country funds. And they don't engage in market timing activities. However, they do rebalance, because failing to do so results in the loss of control over the risk of the portfolio. So, passive investing doesn't mean buy, hold and forget it. It means buy hold and rebalance. But it means even more than that.

For taxable accounts, passive investors also harvest losses for tax purposes whenever they exceed stated levels. So, buy-and-hold should really be called buy, hold, rebalance and tax manage throughout the year (not just at year-end). However, we're not done yet.

Since an investment plan is based on assumptions, passive investors need to re-evaluate their asset allocation decisions whenever any of their assumptions have changed. For example, a large inheritance will cause the need to take risk to fall, allowing you to take less equity risk. Of course, it may also increase your ability (or even willingness) to take risk. Numerous events could cause shifts as well:
  • A birth or death in the family
  • A marriage or divorce
  • A change in job status
  • A disability
As you can see, passive isn't really an appropriate term for what is generally referred to as passive management. The only thing really passive about it is accepting that you'll earn market returns for the asset classes in which you invest. Passive investors regularly rebalance, tax manage and adjust their asset allocation whenever any of the assumptions they made when constructing their plan have changed. In other words, passive management involves more than just being a "couch potato."

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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