Passive management

Passive management is the strategy where a fund manager makes portfolio decisions so as to mimic the performance of a externally specified index. Funds which utilise passive management are called 'index funds'. The ethos of an index fund is aptly summed up in the injunction to an index fund manager: Don't just do something, sit there!

Passive management is most common on the equity market, where index funds track a stock market index. Today, there is a plethora of market indexes in the world, and thousands of different index funds tracking many of them.

Rationale

Implementation

Metrics

At the simplest, an index fund is judged on it's "tracking error". This is defined as the annualised standard deviation of the [tracking error]? between the returns on the index fund and the returns on the index that it is supposed to replicate. Tracking error is computed using the following steps:

  
 Over a stated time-period, compute daily returns on the index fund and daily 
       returns on the index. The computation of returns on the index fund should
       fully account for the fees and expenses that the end-investor suffers.
       The computation of returns on the index should give full credit for dividends
       or interest payments that accrue to the index portfolio. The index variant
       which does this is called the "total return index" (see [index construction]?).
  
 Subtract the two, to obtain a daily time-series of the error between the
       index fund return and the total return index return.
  
 Compute the standard deviation of the error time-series.
  
 Annualise this by multiplying by the square-root of the number of trading
       days a year, which is roughly sqrt(250).

Tracking error is the standard deviation of the random variable, which is the error between index fund return and TR index return over one year. Assuming this error is normally distributed, we can then make inferences such as "The actual error is likely to be smaller than twice the tracking error with a 95% probability". For example, if an index fund exhibits a tracking error of 0.3%, then we can be 95% sure that over a one--year period, the error between the index fund returns and the TR index will be smaller than 0.6%.

Tracking error penalises discrepencies between the index fund and the index, but it does not directly concern itself with portfolio strategies which obtain systematically higher or lower returns. These include fees, riskless efforts to obtain superior returns such as stocklending, and index arbitrage, etc. Hence, an alternative measure that is often preferable in judging index funds is the "information ratio", which is defined as the [Sharpe's Ratio]? of the error time-series. It is the reward divided by risk, i.e. it is the average outperformance of the index fund divided by the tracking error.

Taxonomy

Further reading

  
 AJAY SHAH and KSHAMA  FERNANDES.  "The relevance of index funds for
   pension  investment  in  equities."  In:  "New  Ideas  About  Old  Age
   Security:  Toward  Sustainable  Pension  Systems in the 21st Century,"
   (editors) ROBERT HOLZMANN and JOSEPH STIGLITZ. World Bank, 2001. This is
   a survey article on index funds. It can be accessed at 
   http://www.igidr.ac.in/~ajayshah/public_html/PDFDOCS/ShahFernandes2001_indexfunds.pdf

Related entries -- [index construction]?, [active management]?, [performance evaluation]?, [fees and expenses in fund management]?, Vanguard?, [State Street]?, [Barclays Global]?, [[Standard & Poors]], [[S&P 500]], [index futures]?, [Pension fund management]?.