MBA (Finance) – IV Semester, Investment and Portfolio Management, Unit 5.4
Define Passive Management
Passive management is a process of holding a well diversified portfolio for a long term with the buy and hold approach. Passive management refers to the investor’s attempt to construct a portfolio that resembles the overall market returns. The simplest form of passive management is holding the Index fund that is designed to replicate a good and well defined index of the common stock such as BSE-Sensex or NSE-Nifty. The fund manager buys every stock in the index in exact proportion of the stock in that index. If Reliance Industry’s stock constitutes 5% of the index, the fund also invests 5% of its money in Reliance Industry stock.
Passive Management
The problem in the index fund is the transaction cost. If it is
NSE-Nifty, the manager has to buy all the 50 stocks in market proportion and
cannot leave the stocks with smallest weights to save the transaction costs.
Further, the reinvestment of the dividends also poses a problem. Here, the
alternative is to keep the cash in hand or to invest the money in stocks
incurring transaction cost. Keeping away the stock of smallest weights and the
money in hand fail to replicate the index fund in the proper manner. The
commonly used approaches in constructing an index fund are as follows:
Keeping each stock in proportion to its representation in the index
Holding a specified number of stocks for example 20, which
historically track the index in the best manner.
Holding a smaller set of stocks to match the index in a
pre-specified set of characteristics. This may be in terms of sector, industry
and the market capitalisation.
