Passive Management

Passive management is a way of investing that aims to deliver the return of a market index, minus small costs, rather than trying to beat it. A passive fund buys the securities in the index in the same proportions, or a representative sample of them, and changes its holdings only when the index changes. The main vehicles are index mutual funds and most exchange-traded funds.

It is the counterpart to active management, in which a manager picks and times investments to try to outperform. Passive investing rests on the idea, associated with the efficient market hypothesis, that prices already reflect available information, so beating the market consistently is hard and costly. Index providers such as S&P Dow Jones Indices, MSCI and FTSE Russell design the indices that passive funds follow.

Picture a shopper who, instead of hunting for bargains aisle by aisle, buys a ready-made basket containing a little of everything on the shelves. They will never find the single best deal, but they will never be stuck with only the worst ones either, and they spend almost no time or money choosing.

A passive fund is that ready-made basket. It holds a slice of every company in, for example, the S&P 500, so its result is simply the market's result. The investor gives up the chance to beat the market in return for low fees, wide diversification and a result that is easy to understand.

Most broad equity indices are weighted by market capitalization, so larger companies take a larger share. A fund can track an index in two main ways:

• Full replication. The fund holds every security in the index at its index weight, which is practical for large, liquid indices.
• Sampling or optimization. The fund holds a subset chosen to mimic the index's characteristics, which suits indices with thousands of bonds or small, illiquid shares.

Some ETFs, mainly in Europe, use synthetic replication instead, receiving the index return from a bank through a swap, which adds counterparty risk. The gap between a fund's return and its index is called tracking difference, and its variability is tracking error. A simple form is:

Here $R_{\text{fund}}$ is the fund's return over a period and $R_{\text{index}}$ is the index return over the same period. If an index rises 10 percent in a year and the fund rises 9.93 percent, the tracking difference is −0.07 percentage points, roughly the fund's expense ratio plus trading costs.

The first index fund for institutions was run by Wells Fargo in 1971 for a corporate pension plan. In 1976 John Bogle's Vanguard launched the First Index Investment Trust, the first index mutual fund open to the public, which was widely mocked at the time. The first US-listed ETF, the SPDR S&P 500 Trust, followed in 1993.

Growth was slow for two decades and then rapid. Morningstar data show that by the end of 2023 passive US mutual funds and ETFs held more assets than active ones, about $13.3 trillion against just over $13.2 trillion, and their share rose further in 2024. Large pension funds, sovereign wealth funds and other institutional investors also index large parts of their portfolios.

The main attractions are low cost, broad diversification, tax efficiency from low turnover and transparency. Over long periods these advantages have let index funds beat most comparable active funds after fees, according to S&P's SPIVA scorecards.

Passive investing still involves choices and risks:

• Market risk. An index fund falls with the market and offers no defence in a crash; systematic risk cannot be diversified away.
• Concentration. Cap-weighted indices put more money into whatever has risen most, so a few very large companies can dominate.
• Index design. Choosing an index is itself an active decision, and rules on what to include can be gamed or can force trades at poor prices.

Some academics and active managers argue that if too much money is indexed, fewer investors will research companies and prices could become less efficient; others reply that a small active minority is enough to keep prices honest. A second debate concerns ownership: three large index providers, BlackRock, Vanguard and State Street, are among the largest shareholders of most US listed companies, raising questions about common ownership, competition and how these firms vote. Supporters point to growing stewardship programmes and, more recently, schemes that let fund investors choose how their share of votes is cast.

• Investor.gov: Mutual Funds and ETFs
• S&P Dow Jones Indices: SPIVA research