Passive Management - Rationale

Rationale

The concept of passive management is counterintuitive to many investors. The rationale behind indexing stems from five concepts of financial economics:

1. In the long term, the average investor will have an average before-costs performance equal to the market average. Therefore the average investor will benefit more from reducing investment costs than from trying to beat the average.
2. The efficient-market hypothesis postulates that equilibrium market prices fully reflect all available information, or to the extent there is some information not reflected, there is nothing that can be done to exploit that fact. It is widely interpreted as suggesting that it is impossible to systematically "beat the market" through active management, although this is not a correct interpretation of the hypothesis in its weak form. Stronger forms of the hypothesis are controversial, and there is some debatable evidence against it in its weak form too. For further information see behavioural finance.
3. The principal–agent problem: an investor (the principal) who allocates money to a portfolio manager (the agent) must properly give incentives to the manager to run the portfolio in accordance with the investor's risk/return appetite, and must monitor the manager's performance.
4. The capital asset pricing model (CAPM) and related portfolio separation theorems, which imply that, in equilibrium, all investors will hold a mixture of the market portfolio and a riskless asset. That is, under suitable conditions, a fund indexed to "the market" is the only fund investors need.

The bull market of the 1990s helped spur the phenomenal growth in indexing observed over that decade. Investors were able to achieve desired absolute returns simply by investing in portfolios benchmarked to broad-based market indices such as the S&P 500, Russell 3000, and Wilshire 5000

In the United States, indexed funds have outperformed the majority of active managers, especially as the fees they charge are very much lower than active managers. They are also able to have significantly greater after-tax returns.

Some active managers may beat the index in particular years, or even consistently over a series of years. Nevertheless the retail investor still has the problem of discerning how much of the outperformance was due to skill rather than luck, and which managers will do well in the future.