Last week, we looked at the active fund management approach to investing. Continuing on, this week, I am going to look at another approach, passive fund management. You can them make your own mind up on which approach to use for your money.
What is Passive Fund Management?
Passive fund management is where a fund mirrors a particular index. They are popularly known as Exchange Traded Funds (ETFs). The fund does not make an decisions on what stocks to buy, they copy what is held in the index e.g. S&P 500. It is usually done by buying stocks in the same proportion as held under the chosen index.
Advantages of Passive Fund Management
Why should someone use an passive fund manager for their money:
Cost. It is much cheaper to run a passive fund than an active one. There is less trading involved, so trading costs should be lower. The manager does not have to carry out any company analysis or employ the brightest and most expensive fund managers to make investment calls.
Efficient Market Hypothesis. Many believe that information released on a stock is quickly reflected in its price (see how quickly a share price changes when news about a company is announced). If you believe this , you don’t believe that you can beat the market on a consistent basis and don’t try. Passive fund management will mirror your belief.
Disadvantages of Passive Fund Management
Lack of control. The passive fund must buy what is in the index. The manager has no discretion.
Restrictive buying periods. Most passive funds rebalance its weighting at pre determined dates ie every 6 months. If they rebalance on 1 January, they must buy/sell stock on that date, even if the prices are not favourable on that day.
The goal of passive fund management is to match the index, not to beat it. Again, this comes back to the argument over whether an active fund manager can beat the index over the long term.