Special - Part I: The Unintended Consequences of Passive Investing

Passive management began to capture market share in the aftermath of the 2008 financial crisis.  This shift was due to the realization that the comparatively higher fees charged by active managers would eclipse the alpha (excess returns) that they were able to generate.  This has lead to the belief that passive modeling of the index will outperform an actively managed strategy.  Thus, targeting a low tracking error (the standard deviation in excess of the market) / low fee strategy will deliver the best net performance per market risk.  This paper is a thought experiment that will examine:

  1. The creation of passively managed index funds.
  2. The impact on the equity market as passive funds continue to capture market share.
  3. The use of benchmarks by investment professionals.
  4. The evolution of active management in response to passive management.

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A special thanks to the CFA Institute's Level III program for influencing my thoughts on this topic