Editing Passive management (section)

==Implementation ==

The first step to implementing an index-based passive investment strategy is choosing a rules-based, transparent, and investable index consistent with the investment strategy's desired market exposure. Investment strategies are defined by their objectives and constraints, which are stated in their Investment Policy Statements. For equity passive investment strategies, the desired market exposures could vary by equity market segment (broad market vs. industry sectors, domestic vs. international), by [[Investment style|style]] ([[value investing|value]], [[growth stock|growth]], blend/core), or by other factors ([[Momentum investing|high or low momentum]], [[Low-volatility investing|low volatility]], quality).<ref name=":1">{{citation|last1=Smith|first1=David M.|title=Passive Equity Investing|url=https://www.cfainstitute.org/-/media/documents/protected/refresher-reading/2020/pdf/passive-equity-investing.ashx|page=|publisher=CFA Institute|last2=Yousif|first2=Kevin K.}}</ref>

Index rules could include the frequency at which index constituents are re-balanced, and criteria for including such constituents. These rules should be objective, consistent and predictable. Index transparency means that index constituents and rules are clearly disclosed, which ensures that investors can replicate the index. Index investability means that the index performance can be reasonably replicated by investing in the market. In the simplest case, investability means that all constituents of an index can be purchased on a public exchange.<ref>{{citation|url=https://www.cfainstitute.org/-/media/documents/protected/refresher-reading/2020/pdf/passive-equity-investing.ashx|title=Passive Equity Investing|publisher=CFA Institute|last1=Smith|first1=David M.|page=2|last2=Yousif|first2=Kevin K.}}</ref>

Once an index has been chosen, an [[index fund]] can be implemented through various methods, financial instruments, and combinations thereof.

===Implementation vehicles===
Passive management can be achieved through holding the following instruments or a combination of the following instruments.<ref name=":1" />

'''Index funds''' are mutual funds that try to replicate the returns of an index by purchasing [[Security (finance)|securities]] in the same proportion as in the [[stock market index]].<ref name="nine">John Bogle, Bogle on Mutual Funds: New Perspectives for the Intelligent Investor, Dell, 1994, {{ISBN|0-440-50682-4}}</ref>  Some funds replicate index returns through sampling (e.g., buying [[stock]]s of each kind and sector in the index but not necessarily some of each individual stock), and there are sophisticated versions of sampling (e.g., those that seek to buy those particular shares that have the best chance of good performance). [[Investment fund]]s that employ passive investment strategies to track the performance of a [[stock market index]] are known as [[index fund]]s.

'''[[Exchange-traded fund]]s''' are open-ended, pooled, registered funds that are traded on public exchanges. A fund manager manages the underlying portfolio of the ETF much like an index fund, and tracks a particular index or particular indices. "Authorized participant" acts as market makers for the ETF and delivers securities with the same allocation of the underlying fund to the fund manager in exchange for ETF units and vice versa. ETFs usually offer investors easy trading, low management fees, tax efficiency, and the ability to leverage using borrowed margin.

'''Index futures contracts''' are [[Futures contracts|futures contacts]] on the price of particular indices. Stock market index futures offer investors easy trading, ability to leverage through notional exposure, and no management fees. However, futures contracts expire, so they must be rolled over periodically for a cost. As well, only relatively popular stock market indices have futures contracts, so portfolio managers might not get exactly the exposure they want using available futures contracts. The use of futures contracts is also highly regulated, given the amount leverage they allow investors. Portfolio managers sometimes uses stock market index futures contracts as short-term investment vehicles to quickly adjust index exposure, while replacing those exposures with cash exposures over longer periods.

'''Options on Index Futures Contracts''' are options on futures contracts of particular indices. Options offer investors asymmetric payoffs that could limit their risk of loss (or gain, depending on the option) to just the premiums they paid for the option. They also offer investors the ability to leverage their exposure to stock market indices since option premiums are lower than the amount of index exposure afforded by the options.

'''Stock Market Index Swaps''' are swap contracts typically negotiated between two parties to swap for a stock market index return in exchange for another source of return, typically a fixed income or money market return. Swap contracts exposure investors to counterparty credit risk, low liquidity risk, interest rate risk, and tax policy risk. However, swap contracts can be negotiated for whatever index the parties agree to use as underlying index, and for however long the parties agree to set the contract, so investors could potentially negotiate swaps more compatible with their investment needs than funds, ETFs, and futures contracts.

===Implementation methods===
'''Full replication''' in index investing means that manager holds all securities represented by the index in weights that closely match the index weights. Full replication is easy to comprehend and explain to investors, and mechanically tracks the index performance. However, full replication requires that all the index components have sufficient investment capacity and liquidity, and that the assets under investment management is large enough to make investments in all components of the index.

'''Stratified sampling''' in index investing means that managers hold sub-sets of securities sampled from distinct sub-groups, or strata, of stocks in the index. The various strata imposed on the index should be mutually exclusive, exhaustive (sum to make up the whole index), and reflective of the characteristics and performance of the entire index. Common stratification techniques include industrial sector membership (such as sector membership defined by [[Global Industry Classification Standard|Global Industry Classification Standard (GICS)]]), equity style characteristics, and country affiliation. Sampling within each strata could be based on minimum market-cap criteria, or other criteria that mimics the weighting scheme of the index.

'''Optimization sampling''' in index investing means that managers hold a sub-set of securities generated from an optimization process that minimizes the index tracking error of a portfolio subject to constraints. These sub-sets of securities do not have to adhere to common stock sub-groups. Common constraints include the number of securities, market-cap limits, stock liquidity, and stock lot size.

Globally diversified portfolios of index funds are used by investment advisors who invest passively for their clients based on the principle that underperforming markets will be balanced by other markets that outperform.  A [[Loring Ward]] report in Advisor Perspectives showed how international diversification worked over the 10-year period from 2000–2010, with the Morgan Stanley Capital Index for emerging markets generating ten-year returns of 154% balancing the [[S&P 500]] index, which declined 9.1% over the same period – a historically rare event.<ref name=nine/> The report noted that passive portfolios diversified in international asset classes generate more stable returns, particularly if rebalanced regularly.<ref name=nine/>

[[State Street Global Advisors]] has long engaged companies on issues of [[corporate governance]]. Passive managers can vote against a [[board of directors]] using a large number of shares. Being forced to own stock on certain companies by the funds' charters, State Street pressures about principles of diversity, including [[gender diversity]].<ref name="Atlantic">[https://www.theatlantic.com/business/archive/2017/03/fearless-girl-wall-street/519393/ The Backstory Behind That 'Fearless Girl' Statue on Wall Street], [[Bethany McLean]], Mar 13, 2017, [[The Atlantic]].</ref>

The [[Bank of America]] estimated in 2017 that 37 percent of the value of U.S. funds (not including privately held assets) were in passive investments such as index funds and index ETFs. The same year, BlackRock estimated that 17.5 percent of the global stock market was managed passively; in contrast, 25.6 percent was managed by active funds or institutional accounts, and 57 percent was privately held and presumably does not track an index.<ref>{{cite news |title=Less than 18 percent of global stocks owned by index investors: BlackRock |url=https://www.reuters.com/article/us-funds-blackrock-passive/less-than-18-percent-of-global-stocks-owned-by-index-investors-blackrock-idUSKCN1C82TE |access-date=18 December 2018 |work=Reuters |date=3 October 2017 |language=en}}</ref> Similarly, Vanguard stated in 2018 that index funds own "15% of the value of all global equities".<ref>{{cite news |last1=Sheetz |first1=Michael |title=Gundlach says passive investing has reached 'mania' status |url=https://www.cnbc.com/2018/12/17/gundlach-says-passive-investing-has-reached-mania-status.html |access-date=18 December 2018 |work=www.cnbc.com |date=17 December 2018}}</ref>