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The concept of passive management is the strategy of making as few portfolio changes as possible. The method is beneficial in that in mitigates the costs accrued from making transactions. This is most commonly seen in the equity market by creating index funds. Managers will simply mimic the performance of a market index in an effort to maximize profitability. Many people believe that passive management is counterintutive to the traditional concepts of investment, however, there are a number of rationales behind the strategy.
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Don't Just Do Something, Sit There!
Over the course of time, investors will acquire the same average gains before costs regardless of whether their portfolios are actively or passively managed. These gains are most likely going to be equal to the market average between investment strategies. This means that by limiting the costs of managers making trades and buying securities, a person using the passive management method will ultimately show higher gains. Basically, if one buys a boat that requires no maintenance, it is more profitable than a boat that needs maintenance every year, regardless of how fast it goes.
Due to the overall movement of the market, keeping a stable strategy has many favorable factors. Many investors believe that no particular strategy will result in any higher gains than others. In this way, keeping a stable strategy of passive management is relatively the same as any other methodology.
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Efficient Market Theory
The hypothesis of the efficient market paradigm suggests that it is impossible to use active management to “beat the market." This postulates that the market's price already reflects all known information and merely adjusts to new information in the future as that information is made available. This is heavily involved with behavioral finance theory in which the market is specifically affected by the emotional state of investors, borrowers and consumers as stakeholders.
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Agency Dilemma Theory
The theory of agency dilemma also makes the argument for passive management. With an actively managed fund, investors are forced to monitor the actions of the manager in order to gain the desired financial outcome. Depending on the level of an investor's risk-reward goals, a manager may not see eye-to-eye with the investor, prompting the situation to fall out of control.
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Portfolio Separation Theory
Both the portfolio separation theory and the capital asset pricing model determine that if an asset is added to a well-diversified portfolio, an appropriate rate of return can be assessed. Under the conditions of a stable market, in which prices slowly rise over time, a fund that is indexed to the market can be the only one needed to gain desired returns.
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One way to implement the concept of a passively managed fund is to simply purchase proportional levels of stocks in line with an index. Another way is to simply sample a variety of stocks from each sector of the index. This can be aided by picking specific shares that may be time tested and have the best chance of performing well.
Research shows that while active managers can beat the market in certain years, they are more than likely not going to maintain that skill over time. This has given rise to questions of whether the performance is due to luck rather than skill, further making the argument for a passively managed fund.
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"The Difference Between Active and Passive Management" Get Rich Slowly: http://www.getrichslowly.org/blog/2007/04/19/saving-and-investing-the-difference-between-active-and-passive-management/
"Not All Passively Managed Funds Are Created Equal" Seeking Alpha: http://seekingalpha.com/article/70410-not-all-passively-managed-funds-are-created-equal