The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

PASSIVE STRATEGIES

There are two types of passive strategies: a buy-and-hold strategy and an indexing strategy. In a buy-and-hold strategy, a portfolio of stocks based on some criterion is purchased and held to the end of some investment horizon. There is no active buying and selling of stocks once the portfolio is created. While referred to as a passive strategy, there are elements of active management. Specifically, the investor who pursues this strategy must determine which stock issues to buy.

An indexing strategy is the more commonly followed passive strategy. With this strategy, the manager does not attempt to identify undervalued or overvalued stock issues based on fundamental security analysis. Nor does the manager attempt to forecast general movements in the stock market and then structure the portfolio so as to take advantage of those movements. Instead, an indexing strategy involves designing a portfolio to track the total return performance of a benchmark index. Next we explain how that is done.

Constructing an Indexed Portfolio

In constructing a portfolio to replicate the performance of the benchmark index, sometimes referred to as the indexed portfolio or the tracking portfolio , there are several approaches that can be used. One approach is to purchase all stock issues included in the benchmark index in proportion to their weightings. A second approach, referred to as the capitalization approach, is one in which the manager purchases a number of the largest ...