ASSET MANAGEMENT

BATCH 2013-2015

PASSIVE PORTFOLIO MANAGEMENT

SUBMITTED TO- SUBMITTED BY-

Dr. RITUPARNA DAS AYUSHI GOLECHHA (450)

ASSOCIATE PROF. OF LAW EKTA JANGID (453)

NATIONAL LAW UNIVERSITY, MAHENDRA SINGH (455)

1

JODHPUR MBA IV SEMESTER

DATED- 13-04-2015

TABLE OF CONTENTS

I. PORTFOLIO MANAGEMENT INTRODUCTION................................3

II. CONSTRAINTS.......................................................................................4

III. PORTFOLIO DIVERSIFICATION.........................................................6

IV. BUILDING A PORTFOLIO....................................................................7

V. PASSIVE PORTFOLIO MANAGEMENT.............................................9

VI. PASSIVE PORTFOLIO MANAGEMENT STRATEGY......................12

VII. PROS AND CONS OF PASSIVE PORTFOLIO MANAGEMENT….14VIII. APPROCHES TO PASSIVE PORTFOLIO

MANAGEMENT.............15

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IX. PASSIVE MANAGEMENT- HYBRID STRATEGY...........................16

X. CONSTRUCTION OF PASSIVE PORTFOLIO...................................16

XI. WORKING OF PASSIVE PORTFOLIO MANAGEMENT.................18

XII. BENEFITS OF EMPLOYING PASSIVE PORTFOLIO MANAGEMENT....................................................................................19

XIII. POTENTIAL RISK OF PASSIVE PORTFOLIO MANAGEMENT....21

XIV. WHICH APPROACH WORKS BEST...................................................23

XV. WHY PASSIVE PORTFOLIO MANAGEMENT.................................25

XVI. COMMON MISCONCEPTION ABOUT PASSIVE PORTFOLIO….26 MANAGEMENT

XVII. FUTURE OF PORTOFOLIO MANAGEMENT...................................28

XVIII. CONCLUSION......................................................................................29

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I. PORTFOLIO MANAGEMENT-INTRODUCTION

The art and science of making decisions about investment mix

and policy, matching investments to objectives, asset

allocation for individuals and institutions, and balancing

risk against performance.

Portfolio management is all about strengths, weaknesses,

opportunities and threats in the choice of debt vs. equity,

domestic vs. international, growth vs. safety, and many other

tradeoffs encountered in the attempt to maximize return at a

given appetite for risk.

The single most prominent factor that has spurned the growth

of portfolio management globally has been demographics. As

more and more people across the developed world live longer,

accumulate more wealth and have progressively higher standards

of living, the need for financial security for the ageing

population becomes vital. Increasingly, governments are

withdrawing from the responsibility of providing retirement

benefits to individuals, leading to a reduction in the welfare

system. Corporations are also diminishing their role in the

provision of retirement benefits to their employees.

Individuals themselves are becoming more accountable for their

own financial well-being after retirement. And trends that

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start in developed countries are often later replicated in the

developing world.

Thus, portfolio management as a vehicle for increasing

personal wealth is set to continue in an expansionary phase.

Granted, markets go up and down, and individuals’ inclinations

towards investments in certain assets such as in bonds or in

equities fluctuate overtime. Nonetheless, portfolios or funds

of pooled assets remain a means by which both individuals and

institutions can, over time, enhance the returns on their

savings. The choices of types of funds in which to invest are

also continually evolving as markets change and as innovative

products surface and are incorporated into new categories of

funds.

The goal of portfolio management is to bring together various

securities and other assets into portfolios that address

investor needs, and then to manage those portfolios in order

to achieve investment objectives. Effective asset management

revolves around a portfolio manager’s ability to assess and

effectively manage risk. With the explosion of technology,

access to information has increased dramatically at all levels

of the investment cycle .It is the job of the portfolio

manager to manage the vast array of available information and

to transform it into successful investments for the portfolio

for which he/she has the remit to manage.

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The most vital decision regarding investing that an investor

can make involves the amount of risk he or she is willing to

bear. Most investors will want to obtain the highest return

for the lowest amount of possible risk. However, there tends

to be a trade-off between risk and return, whereby larger

returns are generally associated with larger risk. Thus, the

most important issue for a portfolio manager to determine is

the client’s tolerance to risk. This is not always easy to do

as attitudes toward risk are personal and sometimes difficult

to articulate. The concept of risk can be difficult to define

and to measure. Nonetheless, portfolio managers must take into

consideration the riskiness of portfolios that are recommended

or set up for clients.

II. CONSTRAINTS

The management of customer portfolios is an involved process.

Besides assessing a customer’s risk profile, a portfolio

manager must also take into account other considerations, such

as the tax status of the investor and of the type of

investment vehicle, as well as the client’s resources,

liquidity needs and time horizon of investment.

ResourcesOne obvious constraint facing an investor is the amount of

resources available for investing. Many investments and

investment strategies will have minimum requirements. For

example, setting up a margin account in the USA may require a

minimum of a few thousand dollars when it is established.

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Likewise, investing in a hedge fund may only be possible for

individuals who are worth more than one million dollars, with

minimum investments of several hundred thousand dollars. An

investment strategy will take into consideration minimum and

maximum resource limits.

Tax statusIn order to achieve proper financial planning and investment,

taxation issues must be considered by both investors and

investment managers. In some cases, such as UK pension funds,

the funds are not taxed at all. For these gross funds, the

manager should attempt to avoid those stocks that include the

deduction of tax at source. Even though these funds may be

able to reclaim the deducted tax, they will incur an

opportunity cost on the lost interest or returns they could

have collected had they not had the tax deducted. Investors

will need to assess any trade-offs between investing in tax-

fee funds and fully taxable funds. For example, tax-free funds

may have liquidity constraints meaning that investors will not

be able to take their money out of the funds for several years

without experiencing a tax penalty.

The tax status of the investor also matters. Investors in a

higher tax category will seek investment strategies with

favourable tax treatments. Tax-exempt investors will

concentrate more on pre tax returns.

Liquidity needs

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At times, an investor may wish to invest in an investment

product that will allow for easy access to cash if needed. For

example, the investor may be considering buying a property

within the next twelve months, and will want quick access to

the capital. Liquidity considerations must be factored into

the decision that determines what types of investment products

may be suitable for a particular client. Also, within any fund

there must be the ability to respond to changing

circumstances, and thus a degree of liquidity must be built

into the fund. Highly liquid stocks or fixed-interest

instruments can guarantee that a part of the investment

portfolio will provide quick access to cash without a

significant concession to price should this be required.

Time horizonsAn investor with a longer time horizon for investing can

invest in funds with longer-term time horizons and can most

likely stand to take higher risks, as poor returns in one year

will most probably be cancelled by high returns in future

years before the fund expires. A fund with a very short term

horizon may not be able to take this type of risk, and hence

the returns may be lower. The types of securities in which

funds invest will be influenced by the time horizon

constraints of the funds, and the type of funds in which an

investor invests will be determined by his or her investment

horizon.

Special situations

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Besides the constraints already mentioned, investors may have

special circumstances or requirements that influence their

investment universe. For example, the number of dependants and

their needs will vary from investor to investor. An investor

may need to plan ahead for school or university fees for one

or several children. Certain investment products will be more

suited for these investors. Other investors may want only to

invest in socially responsible funds, and still other

investors, such as corporate insiders or political

officeholders, may be legally restricted regarding their

investment choices.

III. PORTFOLIO DIVERSIFICATION

There are several different factors that cause risk or lead to

variability in returns on an individual investment. Factors

that may influence risk in any given investment vehicle

include uncertainty of income, interest rates, inflation,

exchange rates, tax rates, the state of the economy, default

risk and liquidity risk (the risk of not being able to sell on

the investment). In addition, an investor will assess the risk

of a given investment (portfolio) within the context of other

types of investments that may already be owned, i.e. stakes in

pension funds, life insurance policies with savings

components, and property.

One way to control portfolio risk is via diversification,

whereby investments are made in a wide variety of assets so

that the exposure to the risk of any particular security is

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limited. This concept is based on the old adage ‘do not put

all your eggs in one basket’. If an investor owns shares in

only one company, that investment will fluctuate depending on

the factors influencing that company. If that company goes

bankrupt, the investor might lose 100 per cent of the

investment. If, however, the investor owns shares in several

companies in different sectors, then the likelihood of all of

those companies going bankrupt simultaneously is greatly

diminished.

Thus, diversification reduces risk. Although bankruptcy risk

has been considered here, the same principle applies to other

forms of risk.

IV. BUILDING A PORTFOLIO

Rational investors wish to maximize the returns on their funds

for a given level of risk. All investments possess varying

degrees of risk. Returns come in the form of income, such as

interest or dividends, or through growth in capital values

(i.e. capital gains).

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The portfolio construction process can be broadly

characterized as comprising the following steps:

1. Setting objectives. The first step in building a portfoliois to determine the main objectives of the fund given the

constraints (i.e. tax and liquidity requirements) that may

apply. Each investor has different objectives, time horizons

and attitude towards risk. Pension funds have long-term

obligations and, as a result, invest for the long term. Their

objective may be to maximize total returns in excess of the

inflation rate.

A charity might wish to generate the highest level of income

whilst maintaining the value of its capital received from

bequests. An individual may have certain liabilities and wish

to match them at a future date. Assessing a client’s risk

tolerance can be difficult. The concepts of efficient

portfolios and diversification must also be considered when

setting up the investment objectives.

2 Defining policy. Once the objectives have been set, asuitable investment policy must be established. The standard

procedure is for the money manager to ask clients to select

their preferred mix of assets, for example equities and bonds,

to provide an idea of the normal mix desired. Clients are then

asked to specify limits or maximum and minimum amounts they

will allow to be invested in the different assets available.

The main asset classes are cash, equities, gilts/bonds and

other debt instruments, derivatives, property and overseas

assets. Alternative investments, such as private equity, are

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also growing in popularity, and will be discussed in a later

chapter. Attaining the optimal asset mix over time is one of

the key factors of successful investing.

3 Applying portfolio strategy. At either end of the portfoliomanagement spectrum of strategies are active and passive

strategies. An active strategy involves predicting trends and

changing expectations about the likely future performance of

the various asset classes and actively dealing in and out of

investments to seek a better performance. For example, if the

manager expects interest rates to rise, bond prices are likely

to fall and so bonds should be sold, unless this expectation

is already factored into bond prices. At this stage, the

active fund manager should also determine the style of the

portfolio. For example, will the fund invest primarily in

companies with large market capitalizations, in shares of

companies expected to generate high growth rates, or in

companies whose valuations are low?

A passive strategy usually involves buying securities to match

a preselected market index. Alternatively, a portfolio can be

set up to match the investor’s choice of tailor-made index.

Passive strategies rely on diversification to reduce risk.

Outperformance versus the chosen index is not expected. This

strategy requires minimum input from the portfolio manager.

In practice, many active funds are managed somewhere between

the active and passive extremes, the core holdings of the fund

being passively managed and the balance being actively

managed.

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4 Asset selection. Once the strategy is decided, the fundmanager must select individual assets in which to invest.

Usually a systematic procedure known as an investment process

is established, which sets guidelines or criteria for asset

selection. Active strategies require that the fund managers

apply analytical skills and judgment for asset selection in

order to identify undervalued assets and to try to generate

superior performance.

5 Performance assessment. In order to assess the success of

the fund manager, the performance of the fund is periodically

measured against a pre-agreed benchmark – perhaps a suitable

stock exchange index or against a group of similar portfolios

(peer group comparison).

The portfolio construction process is continuously iterative,

reflecting changes internally and externally. For example,

expected movements in exchange rates may make overseas

investment more attractive, leading to changes in asset

allocation. Or, if many large-scale investors simultaneously

decide to switch from passive to more active strategies,

pressure will be put on the fund managers to offer more active

funds. Poor performance of a fund may lead to modifications in

individual asset holdings or, as an extreme measure, the

manager of the fund may be changed altogether.

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There are two basic approaches to investment management:

1. Active asset management is based on a belief that a

specific style of management or analysis can produce

returns that beat the market.

o The active approach seeks to take advantage of

inefficiencies in the market and is typically accompanied

by higher-than-average costs (for analysts and managers

who must spend time to seek out these inefficiencies).

o Market timing is an extreme example of active asset

management. It is based on the belief that it's possible

to anticipate the movement of markets based on factors

such as economic conditions, interest rate trends or

technical indicators. Many investors, particularly

academics, believe it is impossible to correctly time the

market on a consistent basis.

2. Passive asset management is based on the belief that:

o Markets are efficient.

o Market returns cannot be surpassed regularly over

time.

o Low-cost investments held for the long-term will

provide the best returns.

V. PASSIVE PORTFOLIO MANAGEMENT

Passive portfolio management (also called passive investing)

is a financial strategy in which an investor (or a fund

manager) invests in accordance with a pre-determined strategy

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that doesn't entail any forecasting (e.g., any use of market

timing or stock picking would not qualify as passive

management). The idea is to minimize investing fees and to

avoid the adverse consequences of failing to correctly

anticipate the future. The most popular method is to mimic the

performance of an externally specified index. Retail investors

typically do this by buying one or more 'index funds'. By

tracking an index, an investment portfolio typically gets good

diversification, low turnover (good for keeping down internal

transaction costs), and extremely low management fees. With

low management fees, an investor in such a fund would have

higher returns than a similar fund with similar investments

but higher management fees and/or turnover/transaction cost.

Passive management is most common on the equity market, where

index funds track a stock market index, but it is becoming

more common in other investment types, including bonds,

commodities and hedge funds. Today, there is a plethora of

market indices in the world, and thousands of different index

funds tracking many of them.]

One of the largest equity mutual funds, the Vanguard 500, is a

passive management fund.]The two firms with the largest amounts

of money under management, Barclays Global Investors and State

Street Corp., primarily engage in passive management

strategies.

Rationale

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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 behavioral 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

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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.

Implementation

At the simplest, an index fund is implemented by purchasing

securities in the same proportion as in the stock market

index.[12] It can also be achieved by sampling (e.g. buying

stocks of each kind and sector in the index but not

necessarily some of each individual stock), and there are

sophisticated versions of sampling (e.g. those that seek to

buy those particular shares that have the best chance of good

performance).

Investment funds run by investment managers who closely mirror

the index in their managed portfolios and offer little "added

value" as managers whilst charging fees for active management

are called 'closet trackers'; that is they do not in truth

actively manage the fund but furtively mirror the index.

Collective investment schemes that employ passive investment

strategies to track the performance of a stock market index,

are known as index funds. Exchange-traded funds are hardly

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ever actively managed and often track a specific market or

commodity indices.

Globally diversified portfolios of index funds are used by

investment advisors who invest passively for their clients

based on the principle that underperforming markets will be

balanced by other markets that outperform. A Loring Ward

report in Advisor Perspectives showed how international

diversification worked over the 10-year period from 2000–2010,

with the Morgan Stanley Capital Index for emerging markets

generating ten-year returns of 154 percent balancing the blue-

chip S&P 500 index, which lost 9.1 percent over the same

period – a historically rare event.[12] The report noted that

passive portfolios diversified in international asset classes

generate more stable returns, particularly if rebalanced

regularly.

There is room for dialog about whether index funds are one

example of or the only example of passive management.

VI. PASSIVE PORTFOLIO MANAGEMENT STRATEGIES

Research conducted by the World Pensions Council (WPC)

suggests that up to 15% of overall assets held by large

pension funds and national social security funds are invested

in various forms of passive funds- as opposed to the more

traditional actively managed mandates which still constitute

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the largest share of institutional investments . The

proportion invested in passive funds varies widely across

jurisdictions and fund type .

The relative appeal of passive funds such as ETFs and other

index-replicating investment vehicles has grown rapidly for

various reasons ranging from disappointment with

underperforming actively managed mandates to the broader

tendency towards cost reduction across public services and

social benefits that followed the 2008-2012 Great Recession.[16]

Public-sector pensions and national reserve funds have been

among the early adopters of passive management strategies.

Passive portfolio management strategy refers to the financial

investment strategy where an investor makes an investment as

per the fixed strategy that doesn’t involve any forecasting.

It stresses on minimizing the investing fees and avoiding the

unpleasant results of failing to correctly predict the future.

Passive portfolio management strategy employs the most popular

method of imitating the performance of a superficially

specified index. It is done by retail investors by buying one

or more ‘index funds’. An investment portfolio tracks an index

and achieves low turnover, very low management fees and good

diversification.

The low management fees enable the investor to receive higher

returns in comparison to similar fund investments with higher

management fees or transaction costs. Passive management is

widely used in the equity market and involves tracking of

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stock market index by index funds. However, it is getting more

common in other types of investment including hedge funds,

bonds and commodities. There is vast number of market indexes

all over the world and different index funds (in thousands)

track several of them.

Implementation of Passive portfolio management strategy

An index fund can be implemented by buying securities in the

similar proportion as present in the stock market index.

Sampling can also be done to implement passive portfolio

management strategy.

The sampling involves purchasing each type of stocks from

various sectors in the index but do not include some quantity

of stocks of every individual stock. Some of the sampling

techniques are very advanced and sophisticated that involves

purchasing of specific shares that have high probability of

good performance.

Those investment managers who run the investment funds and

closely follow the index in their managed portfolios; are

called as closet trackers. These investment managers offer

little value as managers and charge fees for active

management. These managers do not actively manage the fund but

secretively follows the index.

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Index funds refer to the collective investment schemes that

utilize passive investment strategies for tracking the

performance of a stock market index. Exchange-traded funds

track commodity indices and a specific market. These are

managed by passive investment strategies rather than active

management.

Advantages of passive portfolio management strategy

Passive portfolio management strategy provides various

advantages as mentioned below.

· Low cost: Passive investment strategy incurs low costs as

compared to active investment counterparts. It provides

meaningful and specific incremental advantage. On other hand,

an active manager is required to add enough value for beating

the cost disadvantage.

· Reduced uncertainty of decision errors: By making

investments, investors are exposed to market risks and passive

investment strategy reduces the uncertainty of decision

errors. In case of active management, the pressure of

achieving the returns that beats the market, may lead to the

extra risk for making the wrong investments.

· Style consistency: Indexing enables the investors to control

their overall allocation by selecting the appropriate indexes.

· Tax efficiency: Indexing is considered as more tax efficient

especially in cases of larger-cap indexes that involve less

trading and which are fairly stable.

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VII. THE PROS AND CONS OF PASSIVE PORTFOLIO MANAGEMENT

Ever since the introduction of passive index funds in the mid-

1970s, there has been an ongoing debate over the merits of

active versus passive management of pension fund assets. Each

year articles chronicle the relative rise and fall in

popularity of each approach to portfolio management. The

advantages and disadvantages of each approach vary with the

size of the portfolio as well as with the characteristics of

the asset classes. In fact, there may be a place for both

forms of asset management in a single investment portfolio.

Active managers attempt to add value over the market-related

returns through security selection and/or market timing by

relying on security analysis and investment research. Passive

management can take on many forms, from immunized fixed income

portfolios to enhanced index funds. The basic features common

to each passive approach are an alignment of the portfolio to

reduce risk relative to a segment of the market, and a

reduction in the research inputs needed to construct the

portfolio. Pure passive portfolios are managed without placing

valuation judgments on the individual assets, economic sectors

of the market, or the market as a whole. Studies of manager

performance and academic research on the efficient market

hypothesis, as well as increased cost consciousness, have led

to the acceptance of passive management as a viable

alternative to active management.

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Example: U.K. AND CONTINENTAL EUROPE PENSION FUND

INVESTING

Segments, such as small cap equity the median manager’s

performance tends to dominate the index performance over time,

thereby weakening the appeal of passive management.

The popularity of index funds ebbs and flows with the

performance of the underlying index.

For example, during the late 1980s, when the performance of

active international equity managers was trending downward

many passive international equity portfolios were established.

However, once the international active managers began to beat

the index in early 1990, the tide shifted back toward active

international equity management.

VIII. APPROACHES TO PASSIVE MANAGEMENT

Index funds are the most popular approach to passive management.

Designed to mirror the performance of a benchmark portfolio,

index funds provide low cost, diversified, broad market

exposure.

An index fund can be constructed to reflect virtually any

commercially available index. The more commonly chosen

underlying indexes include the S&P 500 for large cap equity,

MSCIEAFE for international equity, and the Lehman Aggregate or

Lehman Government/Corporate for domestic fixed income. The

investment mandate given to the index fund manager is to

replicate the performance of the index without an expectation

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of adding additional value relative to the benchmark. Tracking

error measure the degree that the index fund’s returns differ

from that of the benchmark portfolio returns.Typically, an index fund is used to gain a core exposure to an

asset class. The core exposure may be supplemented by

specialty active managers hired to pursue individual styles.

This approach is commonly used by plans whose exposure to an

asset class is very large. The number of active managers

hired, as well as the investment style specialties of the

managers, should be based on the amount of assets to be

managed and the trade-off between program complexity and

additional expected return.

Passive completion funds are specialized index funds. A customized

passive benchmark is constructed that excludes the market

segments in which the active manages operate. Passive

management is used to fill in the areas not covered by

either active or passive management. Active and passive

management represent the two endpoints on the continuum of

investment management strategies. In between these two

extremes are hybrid management styles that blend elements of

both active and passive management. A hybrid or semi-passive

approach typically involves some active decisions, with other

decisions based on index attributes. An important guide to

where an investment product falls on this spectrum is the

degree to which the product is allowed to deviate from the

benchmark. Hybrid portfolios may be restricted in terms of the

number of holdings, the capitalization range, the tolerance

for sector and industry weighting deviations from the

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benchmark, or in the weightings assigned to individual

securities.

For example, a passive hybrid equity strategy might

concentrate on identifying attractive stocks within each

industry without having a view on the relative attractiveness

between industries. That is, a subset of stocks in each

industry sector is held, but the portfolio weight assigned to

each industry is identical to the industry weightings in the

index benchmark.

IX. PASSIVE MANAGEMENT- HYBRID STRATEGY

Active/passive international equity is an interesting hybrid

strategy. The country weightings are actively managed, but

stocks are selected passively

through the use of country specific index funds.

Although passive management has gained acceptance, the

majority of pension assets are still actively managed.

Passive investing is most common among the larger plans.

While plan sponsors are increasingly using passive management

as a complement to active management, it is relatively

uncommon for a plan sponsor to gain the entire asset class

exposure through a passive investment vehicle.

X. HOW SHOULD THE PASSIVE PORTFOLIO BE CONSTRUCTED?There are several different approaches for constructing the

passive portfolio. The method selected can impact the

resulting performance.

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Under a full replication approach, each security in the index is

purchased in proportion to its weight in the index. Over time,

the portfolio holdings are adjusted for additions to or

deletions from the index. This approach ensures an index-like

return with low tracking error since the portfolio is a mini-

version of the index.

There are at least three circumstances where full replication

may not be practical:

1. When there are a large number of securities in an index

2. When some of the securities in the index are relatively

illiquid

3. When the dollar amount invested in each security is so

small that it is not cost effective to hold every security.

The following section on the potential risks of passive

management contains additional discussion of these

circumstances.

Sampling approaches are an alternative to full replication.

For example, when the passive benchmark is a very broad market

index such as the Wilshire 5000, full replication would

require holding and tracking over 6000 securities. In

addition, some of the smaller capitalization securities in the

index are relatively illiquid and therefore more costly to

purchase and sell.

Stratified sampling and random sampling are the two most

commonly used sampling approaches. With stratified sampling,

the universe of securities is divided into cells containing

securities with similar characteristics.

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EXAMPLE-U.K. AND CONTINENTAL EUROPE PENSION FUND

INVESTING

Index is being replicated, these cells might reflect sector,

quality, maturity range, duration, coupon range, and call

provisions. The investment portfolio is constructed by

selecting a limited number of securities from each cell. The

finer the subdivision of the cells, the more closely the

underlying index is replicated and the lower the tracking

error. In general, the number of cells used depends

on the nature, number and liquidity of the securities in the

index.

A benchmark might also be constructed by random sampling, that

is, securities are selected randomly from the universe of

securities that comprise the underlying index.

A third approach to index construction uses a quadratic

optimization model to create a portfolio with minimal residual

risk relative to the benchmark.

The advantage of this approach is that the benchmark can be

tracked quite closely using fewer securities than in the full

replication approach. The disadvantage of this approach is

that the relatively complicated model uses historical data

which may not be representative of the future.

Should Derivatives Be Allowed?

There are several ways in which derivative securities can be

incorporated into a passive portfolio.

Derivatives can be used to replicate the performance of the

underlying index. The primary reason for including derivatives

in a passive portfolio

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is to better manage cash inflows and outflow.

The tracking error of the portfolio can be reduced if cash

inflows received are invested using index futures.

Derivative-based enhanced index funds, which use index futures and

options in addition to equity securities, attempt to provide

positive incremental returns with limited incremental risk.

The cost of establishing such a fund is low due to the low

commission rate of future trades and futures’ high level of

liquidity. Index futures can also be used for “arbitrage,”

that is to take advantage of security mispricing.

XI. WORKING OF PASSIVE PORTFOLIO MANAGEMENT

Example: 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,

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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.

XII. BENEFITS OF EMPLOYING PASSIVE PORTFOLIO

MANAGEMENTThe benefits of passive management are primarily related to

the ability to achieve diversified asset class exposure at a

low cost and without substantial market impact. This is

particularly true when the asset class commitment is very

large. Below we summarize some of the motivating factors for

establishing a passive core position.

Low Cost Asset Class Exposure

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The primary reason for employing a passive management strategy

is to provide low cost market exposure to an asset class. The

reasons for this

low cost exposure follow:

1. Indexation is basically a buy and hold strategy with the

securities being held as long as they remain represented in

the index. Because of the low portfolio turnover, transaction

costs are low.

2. If securities are included in the index, they are

candidates for inclusion in the passive portfolio, thereby

eliminating the costly market research associated with active

management.

3. The trading techniques used by index managers, such as

crossing securities with another index fund and package

trades, result in significant cost savings.

4. When securities lending is permitted, custody fees may be

reduced or the portfolio returns may be enhanced.

5. If futures and options are allowed, the cost of managing

the portfolios may be reduced or the returns may be enhanced.

Management fees are typically stated as a percentage of assets

to be managed. Small investors have higher percentage costs

for active management than larger investors. These percentage

rates usually decline as the amount of assets increase and

reach their lowest rates for accounts of $100 million and

over. The reduced costs of passive management may provide an

additional incentive

for smaller investors to have some funds passively managed.

Diversified Portfolio

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The passive portfolio tracks the performance of an index

containing a large number of securities.

Reduced Risk of Underperformance Relative to the Benchmark

Active managers risk severe underperformance (as well as

fantastic outperformance) relative to their asset class

benchmarks. Because the objective of an index fund is to

produce index-like performance, such a fund offers little or

no residual risk relative to the benchmark. Therefore, neither

severe underperformance nor fantastic outperformance relative

to the benchmark should result from passive management.

However, the potential remains for underperformance relative

to the median active manager.

Longer Term Outlook

Passive management is basically a buy and hold strategy. The

securities included in the benchmark are held while they

remain in the benchmark.

There is much lower portfolio turnover than with active

management, where the focus is often on quarterly performance.

Useful for Structuring Very Large Portfolios

When a very large portfolio is actively managed, the portfolio

returns may tend to resemble market returns even though active

management fees are

paid. This problem stems from the following two sources.

First, the amount given to any manager may be so large that

the implementation of the investment strategy has a

substantial market impact.

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When investment management firms grow larger in terms of

assets under management, they may experience greater

difficulty buying large positions in a small number of

securities without market impact. This may cause the manager

to construct portfolios with larger number of securities. As

the number of different securities held increases, the

portfolio begins to resemble the market and thus to perform

more like the index.

The result is that the fund achieves index-like returns but

the plan sponsor pays active management fees.

Second, a fund structure can have too many actively managed

portfolios. While increasing the number of managers increases

diversification, a fund structure with too many managers can

tend to push the fund toward index-like performance.

When the number of active managers assigned to the same market

segment rises, the number of different securities held will

increase, and the aggregate portfolio will tend to behave like

the index. In these circumstances, passive vehicles serve as a

useful diversified core position in the portfolio. Typically,

active managers are hired to supplement the core position.

Competitive Performance of Passive Management in an Efficient Market

Returns for passive management on a risk-adjusted, after-fee

basis, have been very competitive with median active

management in the large cap equity and fixed-income areas over

much of the last decade. One explanation for this performance

is the degree of efficiency in these markets.

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The greater the market efficiency, the less room that remains

for consistent superior active management results relative to

the benchmark index. The degree of market efficiency varies

with time and by market segment due to the availability of

information, and the comparability of information among

different securities. The large cap domestic equity market is

one of the more efficient markets, while the emerging

international market is the least efficient.

If the efficient market theory is true, it offers a compelling

argument for implementing a passively managed portfolio.

However, the entire growth/value and large cap/small cap

debate is predicated on the notion that markets are not

efficient.

Use in Transitions and Rebalancing

A passive component in the portfolio is also useful for

managing transitions between asset class allocations and in

portfolio rebalancing. The passive fund may be used as a

“parking place” for contributions or for money being moved

from a terminated manager to a manager not yet funded.

If the funds were instead put into a cash account, the asset

class exposure would be lost.

XIII. POTENTIAL RISKS OF PASSIVE PORTFOLIO MANAGEMENT

At times the use of passive management can be expected to have

a negative impact on the overall portfolio performance. The

risks associated with passive management depend on whether the

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passive exposure is a core type exposure or is the only

exposure to the asset class.

Index Related Problems

The most important potential downside to the use of passive

management is the lack of a fully satisfactory passive index

to track. Poor index availability stems from index

construction problems and fundamental inefficiencies in the

universe of securities that the index attempts to represent.

By definition, any capitalization weighted index ( for example

the S&P 500 or MSCI-EAFE) is dominated by large capitalization

securities. As a result of the capitalization weighting, the

performance of larger stocks will have a larger impact on the

overall performance of the index than the performance of

smaller stocks. During the 1980s when domestic large cap

stocks performed well, the result was a positive impact on the

S&P 500 index and on S&P 500 index funds. Typically, active

managers equal-weight the securities in their portfolios

thereby reducing the overall impact of large company

performance.

A second index related problem is the rigidity of buy and sell

decisions imposed by closely following changes in the index.

This may explain the consistent underperformance of the small

cap indexes relative to active small cap managers.

The active managers can ride the winners out of the small cap

range of the index and realize the resulting price

appreciation. However, a small cap index will lose these

successful issues as they rise out of the index’s

capitalization range. Also, a small cap index includes all the

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issues which are falling from higher cap levels due to price

declines in the stock.

Some indexes include non-investable components, such as

illiquid securities that can be traded only at a prohibitively

high cost. Similar problems occur when there is such a large

number of securities in the index that holding all of the

securities is impossible due to cost considerations.

Indices Are Not “The Market”

To the extent that capitalization weighted portfolios are not

mean/variance efficient portfolios (in other words they are

not on the efficient frontier), there are potential gains from

reweighting the securities in the index. While a true passive

portfolio would hold securities in proportion to their

weightings in the index, a semi-passive approach could allow

for the reweighting of the securities in an attempt to improve

the portfolio performance.

Tracking Error

Higher degrees of tracking error typically occur when sampling

methods are used, when transaction costs are high such as in

full replication methods involving illiquid securities, or

when the asset pool of the passive fund manager is small.

Passive Portfolio May Not be Sufficiently Diversified Across Market

Cycles

While index funds typically have outperformed the average

manager in bull market years, the question of whether they

will be able to outperform the average manager in bear market

years has yet to be answered. An index fund has no protection

against downturns in the market. A passive manager’s

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performance follows the index both up and down over the course

of market cycles since he does not have a mandate to deviate

from the index returns in an attempt to reduce the impact of

down markets.

Duration-related Issues for Fixed Income Portfolios

One should nonetheless question an investment approach, such

as a bond index fund, that causes one to systematically

shorten durations when interest rates are absolutely high and

lengthen durations when interest rates are low.

Problems if Majority of Investors Switch to Passive Investing

The competitive returns achieved by passive equity portfolios

were achieved in an era in which the market was dominated by

traditional active managers. If a significant portion of the

market ignores traditional management approaches and bases

investment decisions on other factors, the basic concepts that

support market efficiency are destroyed. The result,

therefore, would be an

increased opportunity for active management.

Portfolio insurance worked when nobody used the approach but

once many started to use it, it ceased to work. Advocates of

market efficiency note that critical assumptions are

1) that investors are rational

2) that information is readily available to all market

participants

3) that they act on it. If a significant part of the

investment world ignores information and acts on some other

basis, they are no longer acting rationally

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and presumably that will create extraordinary opportunities

for the active managers.

XIV. WHICH APPROACH WORKS BEST? Proponents of each believe their approach is the right

one, the one that has the potential to generate the

greatest amount of return over the long term. The two

camps see the investment world in very different ways,

both making logical and passionate arguments for their

viewpoint.

Passive managers generally believe that it is difficult

to beat the market. Therefore, they essentially offer

performance that closely matches an index for those

investors who are unwilling to assume the risks of active

management.

Active managers believe the market can be beaten. While

they can't beat it all the time, many active managers do

believe there are certain irregularities in the market

that can be taken into consideration to achieve

potentially higher returns. Active management strategies also have their

disadvantages.  One of the most obvious is that most

individual investors that try to actively manage their

own investments meet with failure.  This observation is

based on studies by Dalbar, Inc. and others that show

retail mutual fund investors generally do not realize the

long-term returns delivered by mutual funds because of

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frequent switching, usually at inopportune times (buying

high and selling low).

However, it may surprise you to hear that even most

professionals who try active management are not successful. 

During our 15+ years of searching for successful active money

managers, it has been found that most are mediocre, some are

downright terrible, but a select few have very attractive long-

term track records.

Since active management strategies tend to trade more

frequently, they are often not as tax efficient as buy-

and-hold strategies.  For this reason, some investors

choose to place their actively managed investments in a

tax-qualified account such as an IRA or variable annuity;

Some strategies perform well during certain types of

market environments but poorly in others.  A good example

is the tech bubble of the late 1990s when the market was

going straight up.  Some active management strategies

perceived elevated risk during this time and stayed

largely out of the market.  But by doing so, they missed

the crash in 2000;

Active management strategies tend to be more expensive

than buy-and-hold, but it’s important to not judge a

manager solely by the fee.  Always evaluate investment

managers based on performance net of all fees and

expenses to see if they add value over and above their

increased costs; and

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�Finally, active management strategies can sometimes be

more confusing for the average investor than a straight-

forward asset allocation plan.  Many active strategies

are based on proprietary trading models that are closely

guarded by the Advisor, much as is the case in hedge

funds.  That’s another good reason why it’s important to

have a mediator on your side who can help evaluate the

strategy and monitor its ongoing trading.

XV. WHY PASSIVE PORTFOLIO MANAGEMENT

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,

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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.

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XVI. COMMON MISCONCEPTIONS ABOUT PASSIVE INVESTING

An enormous amount of flawed information has circulated in the

active versus passive investing debate. That is to be expected

for an argument that has been raging since disco ruled the

airwaves, when John Bogle and Vanguard launched the first

index mutual fund in 1976. Plus, there’s much at stake, from

the salaries of fund managers to the savings of retirees.

Unfortunately for investors, it isn’t possible to try

different investment philosophies like a pair of bell bottoms.

Instead, choosing a strategy requires a great deal of

research. Whether you lean active or passive, it is important

to recognize fact from fiction so as to make a well-informed

decision on how best to invest your money.

In an effort to help refine the debate, here are some facts to

clear up five common misconceptions about passive investing.

1. There’s no action in passive investing

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If only passive investing was as easy as placing money in an

index fund and waiting for all the money to roll in. In

reality, passive investors can be performers of portfolio

construction, observation and discipline.

When building a portfolio with passive investments such as

index funds, action starts with strategically allocating money

among a variety of asset classes that can potentially help

achieve a long-term financial goal. If those allocations

change, more action is found with passive investors that

diligently rebalance their portfolios by making trades to

return assets back to their original levels so as to stick

with the plan and manage risk.

2. Because of costs, passive investing achieves returns below

market averages

True, but average returns are in the eye of the investor.

Index funds seek to replicate a market index, so even if they

accurately do, net of fees their returns will be below

average. However, index funds generally have lower costs than

active funds, meaning they have higher probabilities of

reaching near-market averages over the long term.

Active funds charge high fees for personnel to conduct trades

and research, which eat away at returns and contribute to an

abysmal historical record of beating or even matching market

averages. So, it’s no surprise that some studies show index

funds are able to outperform the majority of active funds over

time. A 2013 Vanguard study ,for example, attributed better

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index fund performance, on average, to the inability of active

fund managers to consistently beat the markets and lower

expenses. That’s a pretty good average.

3. Passive investing is a cookie-cutter strategy that

underperforms active investing

Detractors of passive investing believe passive investments

can’t beat active investments since they are not tactfully

managed to change with market swings or take advantage of

potential future events. But, there is a benefit from passive

investing’s uniformity, as the same strategy can be followed

from one investor to the next.

Active investors usually shoot themselves in the foot while

attempting to time the market or select promising securities

because of the simple fact they cannot predict the future. A

passive strategy is to stay in the market to capture its

positive returns and eliminate the complex guesswork that

usually proves wrong over the long run.

4. Active investors outperform passive investors during down

markets

In a bear market, active investors typically move investments

to cash in an attempt to avoid heavy losses. Meanwhile,

passive investors by design stay in the market. Therefore,

it’s reasonable to think active investors outperform passive

investors in times of market stress. However, no evidence

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supports this, and in fact, data on the market timing tactics

of active investors as mentioned above is not very positive.

Passive investors weather market slumps through portfolio

diversification and rebalancing. And since they don’t exit the

market, they may be in position to benefit on the days when it

rebounds. The biggest market swings tend to happen during only

a handful of trading days. In a Vanguard study of the S&P 500,

eight of the 20 best days happened within 10 days of one of

the 20 worst days, meaning that jumping ship can cost

investors some of the market’s biggest gains.

5. Passive investing isn’t as tax efficient as active

investing

Since taxes weaken returns, they’re one of the biggest

concerns for investors, especially those in high tax brackets

or in retirement. Undoubtedly, the IRS will get their money,

but passive investing won’t help them collect.

There are minimal trades inside of index funds, making them

more tax efficient than active funds, which have high turnover

rates that could result in substantial taxable gains. Also,

investors in high tax brackets can maintain a diverse, passive

portfolio and limit their tax liabilities by investing in

municipal bond funds that may have special tax exemptions.

As long as there is a market, debates over investment

strategies will continue, with misleading information sure to

follow. However, any investor can see through it all with

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facts. As Will Rogers said, “It isn’t what we don’t know that

gives us trouble. It’s what we think we know that just ain’t

so.”

XVII. THE FUTURE OF PORTFOLIO MANAGEMENT

In the last few decades, portfolio management has become a

more science-based discipline somewhat analogous to

engineering and medicine. As in these other fields, advances

in basic theory, technology, and market structure constantly

translate into improvements in products and professional

practices.

Among the most significant recent theoretical advances in

investments is the recognition that the risk characteristics

of the non tradable assets owned by an individual client, such

as future earnings from a job, a business, or an expected

inheritance, should be included in the definition of that

client’s portfolio. In the institutional area also, there is

an increasing awareness and use of multifactor risk models and

methods of managing risk.

Among the most significant market developments is the

emergence of a broad range of new standardized derivative

contracts—swaps, futures, and options. As active trading in

these standardized products continues to develop, they make

possible the creation of an infinite variety of customized

investment products tailored to the needs of specific clients.

As analysts continue to develop a more comprehensive view of

risk, they also command a wider set of tools with which to

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manage it. In the subsequent chapters, we will encounter many

of these concepts.

ConclusionThe passively managed portfolio can play a useful role in the

overall asset allocation strategy of a pension fund. When

evaluating the appropriateness of a passive allocation, the

pros and cons of a passive portfolio should be considered.

Once the plan sponsor decides to include a passive portfolio

allocation, the plan sponsor needs to consider whether or not

to use derivatives, the impact of market efficiency, and

strategies for implementing the passive portfolio so that the

performance of the portfolio will meet the sponsor’s

expectations.

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