Passive portfolio management is a strategy used by index funds, where the fund purchases and sells stocks to replicate or closely track a market index or benchmark. As an investment strategy, passive portfolio management aims for long-term gains and minimising risks by creating a portfolio in the likeness of a market index. The primary objective here is to mimic the growth of the index, not outperform it.
Given the crucial role that passive portfolio management plays in investing, it becomes imperative to know what passive portfolio management is, its advantages and disadvantages compared to other methods of portfolio management, various underlying strategies, and the different types of passive portfolio management.
What is passive portfolio management?
Think of passive portfolio management as a more hands-off approach to investing in mutual funds and creating a portfolio. Compared to active portfolio management, passive portfolios are not managed extensively, as the objective is to make profits over the long haul. With this primary goal in mind, passive portfolios are designed to move according to a market index or asset class. The portfolio is diverse, with reduced risks and costs. As a passive portfolio looks similar to a market index, the goal is also to copy the performance of the market and not necessarily surpass it. In this portfolio management style, individual stocks may not require monitoring, and you can manage by only monitoring the market index. Even the stocks picked and trades made follow a set of predetermined rules or algorithms, minimising human intervention.
Advantages of passive portfolio management
Passive portfolio management can be incredibly appealing to young investors who lack the knowledge and skills to gain an advantage with active management in the short term. It is also a good fit for investors who value long-term growth and low management costs. With this in mind, let us take a look at some of the major advantages of passive portfolio management.
1. Low costs
As there is limited trading and analysis is typically conducted only on the market index being followed, passive portfolio management offers investors a low-cost management alternative.
2. Consistency
Such portfolios also consistently keep the investor exposed to a broad market, ensuring that market fluctuations have a limited impact on the performance of their portfolio.
3. Tax efficient
Under passive portfolio management, there are fewer short-term capital gains owing to reduced trading, making these portfolios more tax-efficient.
4. Diversification
Modelled after a market index, portfolios under passive portfolio management are inherently diverse.
5. Accessibility
Passive portfolio management services are widely offered by exchange-traded funds (ETFs) and index funds, with minimum investments starting at Rs. 500.
What are strategies for passive portfolio management?
With the myriad benefits that passive portfolio management offers, let us also look at a few prominent strategies under its umbrella that investors and fund managers rely on.
1. Index investing
As the name suggests, this strategy is centred around following a market index like the BSE 500. This ensures that investors get exposure to the market at a low cost, albeit at the cost of flexibility.
2. Asset allocation
This strategy focuses on the diversification of a portfolio across asset classes like bonds and stocks for better risk management and stable returns over the long term. It can be customised to fit your financial goals and risk appetite. However, it does necessitate constant monitoring.
3. Buy-and-hold investing
Simply put, in this strategy of passive portfolio management, assets are bought and held with a long-term perspective from the very beginning. There is minimal trading, hence minimal costs. The aim here is to benefit from compounding returns in the long run.
Disadvantages of passive portfolio management
Here are a few drawbacks of the passive portfolio management strategy.
1. Limited flexibility
Naturally, with limited trading and a set of predefined rules in place, passive portfolio management is less flexible and lacks adaptability to market fluctuations and changes in your financial goals.
2. Exposure to market downturns
As your portfolio is crafted to move according to the market indices, it also makes it vulnerable to risk factors that affect the broader market. Market downturns can have a devastating impact on passive portfolios with investors having the option to either cut their losses or wait for recovery.
3. Tracking error
As individual stocks are not tracked, the market index tracking can have small errors or discrepancies leading to variances in the portfolio value. While the difference is small, it can stack up in the long run.
Types of passive portfolio management
There are three popular methodologies that can be used to craft passive portfolios. Let us examine them one by one.
1. Market-cap weighted portfolios
This approach focuses more on big companies, with the assumption that they are more stable than smaller enterprises. Thus, these portfolios assign more weight to the companies with a large market capitalisation. However, it does run the risk of over-concentration and a big company underperforming could potentially incur significant losses.
2. Equal-weighted portfolios
Think of this approach as the counterargument to the market-cap weighted portfolios. This methodology assigns equal weightage to all the stocks in a portfolio, regardless of the respective market capitalisation. It promotes portfolio diversification but also increases the risk of investments in more volatile companies.
3. Factor-based portfolios
Factor-based portfolios are designed to outperform the market in the long run. This approach promotes making investment decisions based on specific factors like value, quality, and momentum to pick stocks that exhibit these traits.
Key factors to consider for passive portfolio management
With the advantages and disadvantages and various passive portfolio management strategies, it is clear that careful consideration is required when trying to make the right investment choice. Here are some key factors to keep in mind:
1. Asset selection
Picking the right assets is fundamental in trading. The choice becomes even more important under passive portfolio management as the portfolio will largely remain the same over the long haul. Some important facets to remember in choosing assets are volatility, historical performance, and correlation with other stocks in the portfolio.
2. Asset allocation
Allocation refers to the mix of assets in your portfolio. Choose assets depending on your financial goals and risk appetite, and adjust the portfolio over time to align with your dynamic investment goals.
3. Rebalancing
This is an important part of passive portfolio management as tweaks in a passive portfolio are limited. Adjusting your portfolio to periodically align it with your dynamic goals and needs is important to maximise gains.
4. Monitoring performance
It is also crucial for investors to consistently check their passive portfolios to ensure their investment goals are met. This includes evaluating performance metrics like volatility and returns to make changes to the portfolio.
Conclusion
Passive portfolio management is a hands-off investment approach designed to mimic market indices, providing long-term growth, reduced risks, and lower costs. While it has notable advantages such as low fees, consistency, tax efficiency, and diversification, it also comes with limitations like reduced flexibility and vulnerability to market downturns. Understanding various strategies and key factors like asset selection, allocation, rebalancing, and performance monitoring is crucial for maximising the benefits of passive portfolio management.
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