What is Passive Management?

Passive management is an investment strategy whereby an investor or financial advisor makes long-term investments in certain securities and is not influenced by short-term market fluctuations. The management style is the opposite of active management.

How Does Passive Management Work?

Let’s assume you have $100,000 to invest. Based on your circumstances, risk aversion, goals and tax situation, your investment advisor puts $50,000 of the money in stocks, $30,000 in bonds, $10,000 in real estate, and $10,000 in cash. Thus, 50% of the portfolio is in stocks, 30% is in bonds, 10% is in real estate, and 10% is in cash. As time passes, the stocks in the portfolio might rise so much in value that the stock weighting increases from 50% to 70% and consequently reduces the proportion of the other asset classes in the portfolio.

In this situation, the advisor might sell some of the stocks or purchase securities in other asset classes in order to bring the portfolio back to the original weighting (this is often called a constant-mix or dynamic strategy). If the advisor reweights the portfolio frequently, say every three months, then the advisor is said to engage in market timing, tactical asset allocation, or active investing. In both types of rebalancing approaches, the advisor must consider whether the effort and additional transaction costs will increase returns. However, if the advisor refrains from rebalancing the portfolio at all, effectively leaving the investments to do what they may, the advisor is practicing true passive management.

Passive management is not completely passive because unless the investor is purchasing shares of an index fund, he or she (or the advisor) must actively select the securities in which to invest. Passive management commonly relies on fundamental analyses of the company behind a security, such as the company’s long-term growth strategy, the quality of its products, or the company’s relationships with management when deciding whether to buy or sell. However, short-term fluctuations, business cycles, inflation, and responses to new legislation do not influence passive managers.

Why Does Passive Management Matter?

There are several reasons that Warren Buffett and other successful investors favor passive management. First, they espouse the random walk theory, which states that securities prices are random and not influenced by past events. Princeton economics professor Burton G. Malkiel coined the term in his 1973 book A Random Walk Down Wall Street. The idea is also referred to as weak form efficient-market hypothesis. The central idea behind the theory is that it is impossible to consistently outperform the market, particularly in the short term, making passive management the best way to maximize returns.

Second, many experts believe that what an investor buys or sells is more important than when he or she buys or sells it. This is the essence of asset allocation. Because many asset classes tend to rise and fall together, a portfolio’s overall return is much more affected by how the portfolio is allocated rather than the specific securities chosen. A well-known 1986 study by Brinson, Hood and Beebower confirmed that 95% of the time, asset allocation determined a portfolio’s returns rather than the specific securities chosen.

Third, passive management is often cheaper. It can have tax benefits if the IRS taxes long-term capital gains at a lower rate than short-term capital gains. Also, it requires less in trading commissions and advisory fees, which often force investors to have higher return requirements to compensate for these extra costs.