Indexing

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Indexing

A financial strategy in which a fund manager makes as few portfolio decisions as possible, in order to minimize transaction costs, including the incidence of capital gains tax. One popular method is to mimic the performance of an externally specified index.

Passive management is most common on the equity market, where index funds track a stock market index. You must also understand that the S&P 500 does not employ a passive investment strategy. Its is an actively managed low turnover portfolio selected by a committee using investment criteria. ^[1]

From an investors view, securities can go bad real quick. Passive management by its very nature, is slow to remove junk out of the portfolio. Passively investing is not the same as minimizing risk, unless the risk you want to minimize is the risk of not matching the index. Investors are concerned with absolute, not relative risk and return. Minimizing risk is about diversification. ^[2]

Although Malkiel still recommends indexing, or so-called passive investing, there are valid criticisms of too narrow a definition of indexing. The best general index to emulate is one with a broader base. ^[3] Actively managed funds have more choice in terms of assets and may decide against investing in some countries that are experiencing a downturn, or political or economic instability. When following the index, a passive fund does not have this option. ^[4]

If you believe the market is efficient, and it is impossible to outperform the market, then passive investing, or indexing is probably the way to go. Historically passive funds have out performed the majority of active funds ^[5] Part of the index fund advantage has resulted from being 100 percent invested in stocks at all times in a bull market. ^[6]

14c opposed to active, from passivus, capable of feeling or suffering, to suffer. Meaning "not active" is first recorded late 15c. ^[7]