These days, it seems investors have decided active management means frantically throwing money at whatever part of the market shows promise, while passive management is defined as investors too paralyzed to do much of anything.

It's time for some new definitions.

Passive management, which sounds like an oxymoron, has been employed by portfolio managers and institutions for decades. The strategy is based on the belief that the markets are "efficient" -- in the words of Eugene F. Fama, who coined the term in a 1965 Financial Analysts Journal article entitled "Random Walks in Stock Market Prices":

"In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value."

Therefore, stock-picking, market timing, or any other strategy that implies the user is more knowledgeable than everyone else in the market combined is futile and useless. Indeed, "You don't even have to assume the market is efficient," says Steven Evanson, president of Evanson Asset Management. "You just have to assume that people can't add value."

Now, clearly this is where the argument for indexing comes in. (If you want a refresher on the merits of indexing that's backed by a recent study, read this.) If individuals can't consistently beat the market, they should simply strive to be the market. And that's a fine strategy that's easily employed by investors at any level of sophistication and assets.

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But that's not the only strategy. While all indexing strategies fall under the term passive management, not all passive management includes indexing.

Passive portfolios are structured to take advantage of academic theory, rather than manager bravado. Stock or bond purchases and sales are based on academic research, scientific rules and statistical probabilities. Investing decisions are made according to asset class, and the more circumspect decision-making leads to highly efficient cost management and tax management.

"The goal is to get the highest risk-adjusted return for that asset class," says Larry Swedroe, director of research for Buckingham Asset Management and author of Rational Investing in Irrational Times: How to Avoid the Costly Mistakes Even Smart People Make Today.

Model Behavior

Before we go any further, let's take a moment to address what passive management is not: We are not talking about quantitative funds and we're not talking about enhanced indexing.

Quant funds use similar models and screens to determine their stock picking, but the philosophy is different. While some quant funds may fall under the umbrella definition of passive management, "If they're saying that the market price of some securities is wrong, and that the model can find undervalued stocks, then it's just active management using a computer," Swedroe says.

Such models are inherently faulty -- most importantly, if one were actually found to successfully exploit market inefficiencies, the market would rush in and strip away any advantage. (For more on this see " Has Schwab Found the Holy Grail for Investors?)

Likewise, enhanced indexing, or funds that essentially ape an index while simultaneously trying to consistently beat it, is also philosophically closer to active management. Enhanced indexing usually means a fund will have, say, 90% of its assets invested strictly according to an index, while picking stocks to overweight or underweight in the other 10%. That's a particularly tough mandate, and once costs are factored in, near impossible. Think about it: In this scenario, if the enhanced index fund costs 40 basis points more than a traditional index fund (the "enhanced" part doesn't come free), that 10% differential will have to outperform the index by more than 4% every year to make the investment worthwhile.

Actively Managing Passive Investments

True passive management employs three goals: proper asset allocation (which in and of itself is actually an "active" strategy); cost management (the more you can reduce costs, the more you can increase your long-term return); and tax management (lower turnover, careful harvesting of gains and losses, and predictable payouts means taxes won't eat away at returns).

Most individuals can achieve this through a careful balance of index funds and/or exchange-traded funds. Swedroe counsels clients to assess their need for risk (considering, for example, your investment horizon and how closely your earned income is correlated with stock market swings), willingness for risk (the sleep-loss test) and the marginal utility of risk (multimillionaires might suffer from a 20% hit to their portfolio, while a 20% gain wouldn't provide comparable joy).

Passive management, then, strives to beat (and historically does beat) the overall market by proper asset allocation and cost management. "Most people think the diversification effect means that you reduce your risk while getting the market average returns," says Ed Osborn, principal with passive money managers Bingham, Osborn and Scarborough. "But they didn't give economist Harry Markowitz the Nobel Prize for coming up with a theory that generates average returns."

Osborn's firm attacks each client's portfolio by setting up various models that take into account the historical returns of all indexes, and tweaks them accordingly. For instance, he may run the numbers on a series of portfolios that range from 100% domestic large growth companies and nothing international, to just 10% in large caps and 90% in international stocks. "We'll run each of the many different portfolios over different time periods," Osborn says. "And, for instance, we'll choose a portfolio that performed best in, say, a low inflationary environment during an extended economic slowdown."

Professional money managers clearly have far more access to economic and academic research as well as the capability to input that information into portfolio models. They also have another advantage -- access to passively managed mutual funds that are not sold to retail investors. The largest and virtually only passive fund family is Dimensional Fund Advisors, which we will explore later this week.