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23 November 2022 17h30
Source: Banco Carregosa

Passive Management: what it is, its advantages, risks and vehicles

Passive Management: what it is, its advantages, risks and vehicles



Passive Management is one of the main current trends, with record investment amounts. What does it mean? 

In 2021, more than 1.2 trillion dollars were allocated to Passive Management funds, an all time record. Warren Buffet recommends this strategy and studies show that it outperforms Active Management over the long term. But what is Passive Management?

What is Passive Management?


Passive Management is an investment allocation strategy. It is characterised by reproducing the performance of a given benchmark index, as is the case, for example, of the Vanguard 500 Index Fund Admiral Shares[MCF|B1], one of the largest in the market, where the benchmark serves to guide the manager’s work. Thus, Passive Management allows the investor to obtain exposure to the same return as the benchmark, and valuation fluctuations are in line with the market index it tries to replicate.

In Massive Management, it is the fund's own rules which determine the assets that make up the portfolio and which define the benchmark index. For example, a passive fund of global equities could invest in companies that make up the MSCI World index in a way that mirrors its value. Another form of passive management is exchange traded funds (ETFs), which replicate a particular benchmark index.

By definition, Passive Management means that it will not significantly outperform the market, which also translates into a lower investment risk. It differs from Active Management, which aims to obtain a return greater than the benchmark and allows greater freedom in the selection of assets that will make up the portfolio. In other words, while Passive Management aims to follow the benchmark, Active Management aims to outperform the benchmark through investment decisions taken by the manager, but which can also translate into losses compared to what the reference index are registering. In this sense, Passive Management is considered more stable and safer than active or specialised management. But the advantages do not end here.
What are the advantages of Passive Management? Passive Management has several advantages, from greater portfolio diversification (and, consequently, lower risk) to a long track record of performance and predictability.
An investment fund under Passive Management gives you access to a wide asset diversification of companies that make up the chosen benchmark index – both by number of companies and by economic sectors. This means that part of the assets can appreciate while others can depreciate.
On the other hand, since the objective of Passive Management is to track rather than outperform the benchmark, there is less pressure to achieve above-average results and, therefore, the strategy of the portfolios is simpler. This reduces the monitoring needs of the investor.

Moreover, the indices used as benchmarks have a long performance history, in some cases of several decades, having gone through several crises and moments of growth. When viewed over the long term, studies point to efficient performance.

Passive Management: performance of the Vanguard 500 Index Fund Admiral Shares Fund

Source: seeking alpha

Finally, and as a consequence of their nature, Passive Management funds are less exposed to risk insofar as they will accompany the profitability of the index used as benchmark. Due to its advantages, Passive Management may be more suitable for investors who prefer more predictable and diversified investments with greater predictability of return.

What are the risks of Passive Management?


Despite all the advantages, Passive Management has its risks. During periods of market contraction, this strategy is subject to the so-called market risk – if the stocks inherent to the benchmark depreciate, the index will tend to fall as a whole, devaluing the assets. In this situation, an experienced Asset Manager would have protected the investor with a pre-emptive restructuring in other sectors, something that goes against the principles of Passive Management.
On the other hand, and especially in periods of growth, Passive Management can lead to the loss of opportunities in which an Active Management would have invested opportunistically. Finally, another characteristic of Passive Management is that many of the indexes used are weighted by capitalisation. In other words, the larger the capitalisation of a given company, the greater its weight in an investment portfolio, which increases exposure to companies with greater market capitalisation, including those which are eventually overvalued.

Passive Management: what are the instruments available?


Passive Management can be achieved through a number of financial instruments, alone or in combination.

Exchange Traded Funds (ETFs) are one of the most widely used investment vehicles. They are exchange-traded and follow a particular portfolio of assets. As well as replicating benchmark indices, ETFs can also emulate sectoral or thematic indices, such as technology. The difference between Passive and Active ETFs is that the former maximise returns by minimising the number of transactions (purchases and sales) in the portfolio. Traditional investment funds generally follow active management, but there are also investment funds under passive management when they follow a specific index.
Investment funds can be made up of equities, bonds, or both. The former invest in shares of listed companies, usually targeting a specific region, sector or theme. Bond investment funds invest in debt securities, including government bonds, which are generally less risky because governments are generally compliant. Mixed funds are a combination of equities and bonds, which translates into a greater diversification of product types and, therefore, also of the associated risk.

Banco Carregosa can assist you in Passive and Active Management 


What is the best strategy for you? There is no universal answer; it all depends on the objectives, dynamics and knowledge of each investor. In the case of Passive Management, for example, the investor should be prepared for a long-term investment, with moderate return expectations and low risk.

Active Management is indicated for those seeking to "beat” the market and who expect their return to outperform the benchmark indices. To choose the best approach for your case, in Banco Carregosa you will find a team of experienced professionals trained to help you make informed choices.

In risky contexts, the professional and specialised advice offered by Banco Carregosa is key to protecting your investments and assets. Contact our team and benefit from continuous, customised and experienced monitoring.