Equity Valuation and Portfolio Management

PASSIVE MANAGEMENT

The generally poor performance of traditional investment management approaches helped to motivate the development, in the late 1960s and the 1970s, of new theories of stock price behavior. The efficient market hypothesis and random walk theory, the products of much research, offered a reason for the meager returns reaped by traditional investment managers: Stock prices effectively reflect all information in an efficient manner, rendering stock price movements random and unpredictable. Efficiency and randomness provided the motivation for passive investment management; advances in computing power provided the means.

Passive management aims to construct portfolios that will match the risk-return profiles of underlying market benchmarks. The benchmark may be core equity (as proxied by the S&P 500 or other broad index) or a style subset (as proxied by a large-cap growth, large-cap value, or small-cap index). Given the quantitative tools at its disposal, passive management can fine-tune the stock selection and portfolio construction problems in order to deliver portfolios that mimic very closely both the returns and risks of their chosen benchmarks.

Passive portfolios, unlike traditional portfolios, are disciplined. Any tendencies for passive managers to succumb to cognitive biases will be held in check by the exigencies of their stated goals—tracking the performances of their underlying benchmarks. Their success in this endeavor also means that the resulting portfolios ...