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Also known as reactive or passive investing, passive management is an investment strategy in which the trading is conducted by following the movement on a market index. This is in contrast to active management, in which there is an attempt to analyze and predict future movements as a means of beating the market; the passive approach seeks to simply ride the trends as a means of generating returns. This type of financial strategy is often used to manage some types of mutual funds, as well as exchange-traded funds or ETFs.
Proponents of passive management agree that this approach can be effective, since it is based on all the information that is accumulated by markets, and the resulting movement of those markets. By choosing to passively follow a market index instead of utilizing various strategies to create elaborate investment orders, risk is minimized and the chances for a reasonable return are enhanced. The fact that index funds tend to perform at a higher rate of return than most actively managed funds is often cited as proof of the efficacy of passive management.
Those who do not see passive management as the most efficient means of investing note that, while the return on index funds is consistent and often better than many actively managed funds, the approach works best in a stable marketplace. Should the market itself become more volatile, and the underlying assets for the fund become somewhat unstable, the need to use different strategies to minimize loss becomes quickly apparent. For this reason, relying solely on passive management may or may not be the best way to administer a fund.
While passive management is a more reactive approach than other investment strategies, the method does not mean that fund administrators simply ignore a market until some sort of shift occurs. Most administrators using this passive approach will monitor the movement daily and take action to protect the interests of the fund and its investors if they believe the market movements indicate the need. The difference with this approach is that changes tend to occur less frequently than with other methods that rely on constant buying and selling activity to generate some sort of relative return.
The effectiveness of passive management is most clearly illustrated when the investments associated with the fund have a long history of stability, and when there is relatively little potential for sudden shifts in the marketplace that could be anticipated and addressed with an active approach. As with any type of investment management strategy, there is some inherent risk with passive management. Depending on the assets in the fund and the financial goals of the investor, the risk may be very low and the approach can yield an attractive rate of return.