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The Difference Between Active Management and Passive Management

(This week, we're looking at the differences between indexing and passive management. To start, we'll first discuss the differences between active management and passive management to get a better handle on being passive.)
Believers in the Efficient Market Hypothesis invest with the assumption that while it's possible to outperform the market, the odds of doing so are so low that it doesn't pay to play the game. The low odds of success are why Charles Ellis called active management the loser's game and passive investing the winner's game.

Active managers attempt to outperform by market timing and/or stock selection strategies. The difference between active management and passive management is that passive investors don't engage in fundamental or technical analysis. (However, this comes with the caveat that based on a large body of academic research some otherwise "passive" funds are now incorporating momentum into their strategies.) Passive investors simply accept the returns of the asset classes in which they invest. They accomplish this by investing in vehicles that buy and hold all stocks that meet certain criteria.

There are basically two ways to invest passively:

  • Indexing
  • Passive asset class investing
Indexing and passive asset class investing are similar in the way that rectangles and squares are similar. While all squares are rectangles, not all rectangles are squares. Similarly, while all index funds are passively managed, not all passively managed funds are index funds. Let's explore the differences to see if there are advantages to either strategy.

Index funds generally buy and hold all the securities within a particular index in a market cap weighted fashion. Thus, an S&P 500 Index fund would own all 500 stocks in the index, but not an equal amount of each stock. The largest holding might, for example, be 5 percent of the entire portfolio.

There are many indexes, and corresponding index funds, in which an individual can choose to invest. Examples include the S&P 500 (a large company index), the S&P Barra 400 indexes (midcaps) and the S&P Barra 600 indexes (small-caps). Of course, there are also indexes and corresponding funds for asset classes such as international stocks (such as the MSCI EAFE indexes) and REITs (such as the Dow Jones US Select REIT Index).

Very broad market index funds -- such as those representing the Russell 2000 (a small-cap index) or Wilshire 5000 (a domestic total market index) -- may not actually hold all the stocks within its index. Since the very smallest stocks in these broad indexes will constitute a tiny percentage of the holdings, and the trading costs can be high in these smallest of stocks, an index fund might sample the holdings so the fund has similar risk characteristics to its benchmark index (such as like same exposure to all industries).

The benefits of indexing are very clear. First, because there's no fundamental or technical analysis occurring, the costs to run an index fund are very low. Second, because of the buy-and-hold philosophy the turnover is generally low, especially relative to actively managed funds. Low turnover not only holds down the cost of trading, but it also leads to greater tax efficiency.

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