Passive portfolio management strategy refers to the financial investment strategy where an investor makes an investment as per the fixed strategy that doesn’t involve any forecasting. It stresses on minimizing the investing fees and avoiding the unpleasant results of failing to correctly predict the future.
Passive portfolio management strategy employs the most popular method of imitating the performance of a superficially specified index. It is done by retail investors by buying one or more ‘index funds’. An investment portfolio tracks an index and achieves low turnover, very low management fees and good diversification.
The low management fees enable the investor to receive higher returns in comparison to similar fund investments with higher management fees or transaction costs. Passive management is widely used in the equity market and involves tracking of stock market index by index funds. However, it is getting more common in other types of investment including hedge funds, bonds and commodities. There is vast number of market indexes all over the world and different index funds (in thousands) track several of them.
Implementation of Passive portfolio management strategy
The sampling involves purchasing each type of stocks from various sectors in the index but do not include some quantity of stocks of every individual stock. Some of the sampling techniques are very advanced and sophisticated that involves purchasing of specific shares that have high probability of good performance.
Those investment managers who run the investment funds and closely follow the index in their managed portfolios; are called as closet trackers. These investment managers offer little value as managers and charge fees for active management. These managers do not actively manage the fund but secretively follows the index.
Index funds refer to the collective investment schemes that utilize passive investment strategies for tracking the performance of a stock market index. Exchange-traded funds track commodity indices and a specific market. These are managed by passive investment strategies rather than active management.
Advantages of passive portfolio management strategy
Passive portfolio management strategy provides various advantages as mentioned below.
· Low cost: Passive investment strategy incurs low costs as compared to active investment counterparts. It provides meaningful and specific incremental advantage. On other hand, an active manager is required to add enough value for beating the cost disadvantage.
· Reduced uncertainty of decision errors: By making investments, investors are exposed to market risks and passive investment strategy reduces the uncertainty of decision errors. In case of active management, the pressure of achieving the returns that beats the market, may lead to the extra risk for making the wrong investments.
· Style consistency: Indexing enables the investors to control their overall allocation by selecting the appropriate indexes.
· Tax efficiency: Indexing is considered as more tax efficient especially in cases of larger-cap indexes that involve less trading and which are fairly stable.