McGraw-Hill

4 IntrOdUdiOn
analysis of an ever-increasing flood of data, security prices would
become more efficient. Ironically, the vast improvement in investment
tools over this period, including the dissemination and collection
of data, as well as its analysis, may have created conditions that
made profiting from those tools more difficult,
not impossible.
If analysis aimed at selecting individual securities that could
provide superior returns was futile, active investing was a loser‘s
game. In that case, the solution seemed be to to shift the emphasis
from security selection to the task of constructing portfolios that
would offer the market’s return at the market’s level of risk. If you
can’t outperform the market, passive investing held out the possibility
of becoming one with the market.
Passive management uses portfolio construction techniques
that utilize statistical sampling or full index replication to deliver
portfolios that mimic the returns and risks of an underlying market
benchmark. As the trading required to keep portfolios in line with
underlying indexes is typically less than that required to beat the
dexes, transaction costs for passive management are generally
lower than those incurred by active investment approaches. As
much of the investment process can be relegated to computers, the
management fees for passive management are also modest. For the
same reason, the number of securities that can be included in any
given passive portfolio is virtually unlimited.
Passive management thus has the scope to match the riskreturn
profiles of any number of underlying market benchmarks.
Today, there are passive, or index, funds tied to market indexes
such as the S&P 500 or Russell 3000. There are also specialized index
funds designed to deliver the performance of market style subsets
such as growth, value, or smaller-capitalization stocks.
Passive management has no insight, however. It does not attempt
to pursue or offer any return over the return of the .relevant
benchmark. If the market is as efficient as passive managers assume,
of course, such excess returns are unattainable.
Where Traditional Active Management Fails
The .inability of traditional active managers on average to perform
up to expectations suggested to efficient market theorists that the
market could not be bested, that pricing was so efficient as to pre-