Passive Portfolio Management: Meaning, Strategies

Passive portfolio management is an investment strategy that aims to replicate the performance of a market benchmark or index, rather than trying to outperform it. Let’s find out more about it below.

What is Passive Portfolio Management?

Passive portfolio management is an investment strategy that aims to replicate the performance of a benchmark or specific market index, such as the Nifty 50, rather than trying to outperform it. There are no actively chosen stocks in this case; rather, investors use a buy-and-hold approach, usually through ETFs (exchange-traded funds) or index funds, to mirror the index's weightings and composition. You may call it an index fund investing or ETF portfolio management strategy from this viewpoint. 

• Low Costs 

A passive investment strategy may help lower your overall costs. These portfolios are more cost-effective because they require less active management and continuous tracking. They need minimal trading, research, and analysis. These funds do not require active stock selection and hence have lower expense ratios (mostly 0.1-0.3%) than actively managed funds. Minimal trading also leads to lower portfolio turnover and brokerage commissions. 

• Consistency 

Passively managed portfolios offer consistent, market-synced returns, which may be more predictable in the long run than those of actively managed funds. By remaining invested through multiple market cycles, the strategy is suitable for long-term wealth creation. Since the strategy operates under predefined, stringent regulations, there is no risk that any fund manager will make poor investment decisions. 

• Tax Efficient 

Passive portfolio management can be more tax-efficient, generating fewer taxable events. Since assets are held rather than frequently sold, there are lower short-term capital gains, thereby leading to lower tax-related liabilities. It may lead to higher net returns for investors. 

• Diversification 

Passive funds are tailored to mirror broad market indexes, thereby enabling built-in diversification. With investments in a broad range of stocks across multiple sectors, passively managed portfolios spread risk and reduce the impact of any one company's underperformance. Investors can gain access to a whole market segment with just one transaction. 

• Accessibility 

Passive portfolio management services, such as index funds and ETFs, are more accessible to all kinds of investors. The entry investment amounts are very low, making the strategy better suited to beginners who want a hands-off, autopilot approach to their investments. 

Strategies for Passive Portfolio Management

Some passive portfolio management strategies include the following: 

• Index Investing

Index investing is about building a portfolio mirroring a particular market index, such as the Sensex or Nifty 50. Investors usually buy ETFs (exchange-traded funds) or index mutual funds to replicate the performance of the index. This is about buying all index securities at their respective weights, while also buying a representative sample of index components to lower transaction costs. 

• Asset Allocation

This is the process of dividing portfolios across multiple asset classes, including bonds, stocks, and cash equivalents. This helps optimise returns and manage risks depending on the investor’s risk appetite, objectives, and time horizon. This reduces the risks associated with single asset classes, while the portfolio is also periodically adjusted to maintain the target allocation. 

• Buy-and-hold investing

The buy-and-hold investment strategy is a long-term plan in which investors buy securities and hold them for several years. They ignore short-term fluctuations and volatility in the market, while the core assumption is that markets are likely to rise in the long run, enabling investors to benefit from compounding returns. This lowers commissions, taxes, and transaction costs while removing emotion from the decision-making process. 

Disadvantages of passive portfolio management

Now that you know about some of the advantages of passive portfolio management, it is time to look at the disadvantages.

• Limited Flexibility 

Passive portfolio management offers limited adaptability, as it is designed to replicate a particular index. Hence, they cannot swiftly change their holdings in response to economic cycles or market shifts. Passive managers cannot make strategic decisions to leverage short-term market opportunities or to tactically avoid underperforming sectors. They have to follow rigid and predefined rules in this case. In bear markets, managers cannot shift to cash or defensive assets to safeguard capital. 

• Exposure to Market Downturns 

Passive portfolios are tailored to the market, but this means they are fully exposed to market risks. Hence, if the market crashes, then the portfolio will also dip. Passive funds cannot swiftly pivot away from sectors which are crashing or other stocks, forcing investors to either sell at a loss or wait for long-term recovery. Since many passive funds are weighted by market cap, they may be overexposed to overvalued and large companies. This may lead to major losses if these companies experience any decline. 

• Tracking Error

Tracking error measures the divergence between a fund's performance and the index it mimics. Higher tracking errors mean that the fund is not following its benchmark accurately. Since ETFs and index funds incur operating costs, their returns may lag the index at times, leading to persistent tracking differences. Replication issues may also arise from trading commission costs, cash holdings, and other factors. 

Types of Passive Portfolio Management

Some of the types of passive portfolio management include: 

• Market-Cap Weighted Portfolios 

These portfolios assign a higher weight to companies with larger market capitalisation. Hence, they more effectively mirror the broad market index structure. 

• Equal-Weighted Portfolios 

This is an approach in which equal weight is given to every security or stock in the portfolio, irrespective of market capitalisation. This enables varying diversification advantages as compared to market-cap weighting. 

• Factor-Based Portfolios 

This strategy, also known as Smart Beta, is a smart passive strategy in which securities are selected based on specific factors. These include momentum, quality, value, etc. In this case, the aim is to achieve lower risk or higher returns than conventional market-cap-weighted indexes in the long run. 

Key Factors to Consider for Passive Portfolio Management

Here are some of the main factors to consider for passive portfolio management. 

• Asset Selection

Choose low-cost index funds or ETFs (exchange-traded funds) that track well-diversified major indices (BSE Sensex, Nifty 50, S&P 500). The strategy ensures returns at market-average levels. You should choose funds with the lowest possible expense ratios, ideally lower than 0.3%, since higher fees will compound into losses over the long term. 

Select funds with low tracking errors, while larger funds or ETFs with higher AUM (assets under management) are usually more liquid and stable (which makes buying and selling easier). 

• Asset Allocation

You should determine the appropriate asset class mix (debt, equity, gold, etc.) based on your investment horizon and risk tolerance. You can consider passive as your core for stability, while allocating the remainder for thematic or higher-risk investments if needed. 

Ensure the portfolio is diversified across multiple geographies and sectors to reduce the risk of overexposure to any single segment. The asset class mix may include growth-oriented index funds, debt index funds, and possibly global index funds for diversifying geographically. 

• Rebalancing

Portfolios are periodically rebalanced or adjusted, usually once a year or every six months. The goal here is to restore the asset allocation to its original target mix. The goal is to rebalance only when any asset class deviates from the target by a major percentage. Considering tax implications is necessary when using cash flow to buy underperforming asset classes rather than sell overperforming assets.

• Monitoring Performance

Passive portfolios do not require frequent, consistent monitoring. The portfolio should be reassessed annually to ensure it aligns with your risk tolerance, financial objectives, and current life stage. Performance should be evaluated against the index or target benchmark to ensure accurate tracking without underperformance. Check the change in the expense ratio and the annual tracking errors at your end. 

Conclusion

Passive portfolio management may be a more cost-effective and easier strategy for beginners to adopt. It does fall short in swiftly adapting to market opportunities and risks, though it does not depend on the fund manager's skills, unlike actively managed funds. You should consider these strategies if you’re a beginner seeking a hands-off, more predictable approach to investing in the market.