In this article, Youssef LOURAOUI (Bayes Business School, MSc. Energy, Trade & Finance, 2021-2022) elaborates on the concept of passive investing.
This article will offer a concise summary of the academic literature on passive investment. After that, we’ll discuss the fundamental principles of passive investment. The article will finish by establishing a link between passive strategies and the Efficient Market Hypothesis.
Review of academic literature on passive investing
We can retrace the foundations of passive investing to the theory of portfolio construction developed by Harry Markowitz. For his theoretical implications, Markowitz’s work is widely regarded as a pioneer in financial economics and corporate finance. For his contributions to these disciplines, which he developed in his thesis “Portfolio Selection” published in The Journal of Finance in 1952, Markowitz received the Nobel Prize in economics in 1990. His ground-breaking work set the foundation for what is now known as ‘Modern Portfolio Theory’ (MPT).
William Sharpe (1964), John Lintner (1965), and Jan Mossin (1966) separately developed the Capital Asset Pricing Model (CAPM). The CAPM was a huge evolutionary step forward in capital market equilibrium theory because it enabled investors to appropriately value assets in terms of their risk. The asset management industry intended to capture the market portfolio return in the late 1970s, defined as a hypothetical collection of investments that contains every kind of asset available in the investment universe, with each asset weighted in proportion to its overall market participation. A market portfolio’s expected return is the same as the market’s overall expected return. But as financial research evolved and some substantial contributions were made, new factor characteristics emerged to capture some additional performance.
Core principles of passive investing
Positive outlook: The core element of passive investing is that investors can expect the stock market to rise over the long run. A portfolio that mimics the market will appreciate in lockstep with it.
Low cost: A passive strategy has low transaction costs (commissions and market impact) due to its steady approach and absence of frequent trading. While management fees required by funds are unavoidable, most exchange traded funds (ETFs) – the vehicle of choice for passive investors – charge much below 1%.
Diversification: Passive strategies automatically provide investors with a cost-effective method of diversification. This is because index funds diversify their risk by investing in a diverse range of securities from their target benchmarks.
Reduced risk: Diversification almost usually results in lower risk. Investors can also diversify their holdings more within sectors and asset classes by investing in more specialized index funds.
Passive investing and Efficient Market Hypothesis
The Efficient Market Hypothesis (EMH) asserts that markets are efficient, meaning that all information is incorporated into market prices (Fama, 1970). The passive investing strategy is built on the concept of “buy-and-hold,” or keeping an investment position for a lengthy period without worrying about market timing. This latter technique is frequently implemented through the purchase of exchange-traded funds (ETF) that aim to closely match a given benchmark to produce a performance that is comparable to the underlying index or benchmark. The index might be broad-based, such as the S&P500 index in the US equity market for instance, or more specialized, such as an index that monitors a specific sector or geographical zone.
A study from Bloomberg on index funds suggests that passive investments lead 11.6 trillion $ in the US domestic equity-fund market. Passive investing accounts for approximately 54% of the market, owing largely to the growth of funds tracking the S&P 500, the total US stock market, and other broad US indexes. Large-cap stocks in the United States are widely recognized as the world’s most efficient equity market, contributing to passive investing’s dominance. The $6.2 trillion in passive assets represents less than a sixth of the US stock market, which currently has a market capitalization of approximately $40.4 trillion (Bloomberg, 2021).
Figure 1 depicts the historical monthly returns of the S&P500 highlighting the contraction periods in orange. It is considered as a key benchmark that is heavily tracked by passive instruments like Exchange Traded Funds and Mutual Funds. In a two-decade timeframe analysis, the S&P managed to offer an annualised 5.56% return on average coupled with a 15.16% volatility.
Figure 1. S&P500 historical returns (Jan 2000 – November 2021).
Source: Computation by the author (data source: Thomson Reuters).
Estimation of the S&P500 return
You can download an Excel file with data for the S&P500 index returns (used as a representation of the market).
Why should I be interested in this post?
If you are a business school or university undergraduate or graduate student, this content will help you in grasping the concept of passive investing, which is in practice key to investors, and which has attracted a lot of attention in academia.
Related posts on the SimTrade blog
▶ Youssef LOURAOUI Portfolio
▶ Youssef LOURAOUI Alpha
▶ Youssef LOURAOUI Factor Investing
▶ Youssef LOURAOUI Origin of factor investing
▶ Youssef LOURAOUI Alternatives to market-capitalisation weighted indexes
▶ Youssef LOURAOUI Markowitz Modern Portfolio Theory
▶ Jayati WALIA Capital Asset Pricing Model (CAPM)
Useful resources
Academic research
Lintner, J. 1965a. The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets. The Review of Economics and Statistics, 47(1): 13-37.
Lintner, J. 1965b. Security Prices, Risk and Maximal Gains from Diversification. The Journal of Finance, 20(4): 587-615.
Mangram, M.E., 2013. A simplified perspective of the Markowitz Portfolio Theory. Global Journal of Business Research, 7(1): 59-70.
Markowitz, H., 1952. Portfolio Selection. The Journal of Finance, 7(1): 77-91.
Mossin, J. 1966. Equilibrium in a Capital Asset Market.Econometrica, 34(4): 768-783.
Sharpe, W.F. 1963. A Simplified Model for Portfolio Analysis.Management Science, 9(2): 277-293.
Sharpe, W.F. 1964. Capital Asset Prices: A theory of Market Equilibrium under Conditions of Risk. The Journal of Finance, 19(3): 425-442.
Business analysis
JP Morgan Asset Management, 2021.Glossary of investment terms: Passive Investing
Bloomberg, 2021. Passive likely overtakes active by 2026, earlier if bear market
About the author
The article was written in November 2021 by Youssef LOURAOUI (Bayes Business School, MSc. Energy, Trade & Finance, 2021-2022).