Differences Between Active and Passive Mutual Funds

Understand the differences between passive mutual funds and active mutual funds with this easy guide.
Differences Between Active and Passive Mutual Funds
4 mins read
16 Feb 2024

Starting your journey of wealth creation through mutual funds is exciting, but choosing between active and passive investments can be confusing. How do you pick the best option for your financial goals? Explore the differences between active and passive funds to understand their benefits. This knowledge will help you make informed decisions. Whether you prefer active management or passive index tracking, understanding these investment styles is crucial for aligning your strategy with your financial goals.

What is an actively managed portfolio?

An actively managed portfolio is a collection of securities that are selected and managed by a professional fund manager. The fund manager aims to beat the performance of a benchmark index, such as the Nifty 50 or the Sensex, by using various strategies, such as market timing, stock picking, sector rotation, and asset allocation. The fund manager has the discretion to buy and sell securities according to their research and analysis.

How do actively managed funds work?

Actively managed funds charge a fee to investors for the services of the fund manager and the operational costs of the fund. This fee is called the management fees and is included in the express ratio which is expressed as a percentage of the fund’s assets under management (AUM). The expense ratio reduces the returns of the fund and varies depending on the fund’s strategy and asset class.

What is a passively managed portfolio?

A passively managed portfolio is a collection of securities that are designed to replicate the performance of a benchmark index, such as the Nifty 50 or the Sensex. The portfolio does not involve any active decision making by a fund manager, but rather follows a set of rules or a formula to match the composition and weightage of the index. The portfolio is rebalanced periodically to reflect any changes in the index.

How does a passively managed fund work?

Passively managed funds charge a lower fee to investors than actively managed funds, as they do not require any active intervention by a fund manager or incur high transaction costs. This fee is also called the management fees and is included in the expense ratio which is expressed as a percentage of the fund’s AUM. The expense ratio of passively managed funds is generally lower than that of actively managed funds.

Active vs. passive funds: Differences between the two

Here are some of the key differences between active and passive funds:

  • Nature: Active funds are more dynamic and flexible, as they can adapt to changing market conditions and opportunities. Passive funds are more static and rigid, as they follow a predetermined strategy and do not deviate from the index.
  • Expense ratio: Active funds have a higher expense ratio than passive funds, as they incur more costs for the fund manager’s expertise, research, and trading. Passive funds have a lower expense ratio than active funds, as they have lower operational and transaction costs.
  • Risk: Active funds have a higher risk than passive funds, as they are subject to the fund manager’s skill, judgment, and errors. Passive funds have a lower risk than active funds, as they eliminate the human factor and closely mirror the index, resulting in lower volatility and tracking error.

Active vs. passive funds – Tabulating the differences

Differences

Active mutual funds

Passive mutual funds

Definition

Created around a specific theme or strategy by experts

Designed to replicate the performance of an index like SENSEX or NIFTY

Goal

Aim to surpass the performance of the broad market index (benchmark)

Seek to replicate or match the performance of the market index

Expense Ratio

Ranges from 0.5% to 2.5% depending on equity or debt composition

The expense ratio does not exceed 1.25%

Management

Fund managers select underlying securities based on market conditions, fund theme, and objectives

Simply track market indices; no regular fund management required

Tax Efficiency

Higher turnover may lead to greater capital gains distributions compared to passive funds

Capital gains distributions tend to be lower compared to actively managed funds

Cost

These funds typically incur higher costs than passive funds due to the need for more analysis, research, and trading

Passive funds generally have lower expense since the fund manager does not actively select securities beyond those in the tracked index


Pros and cons: Active vs. passive investing

Here are some of the pros and cons of active and passive investing:

  • Pros of active investing: Active investing may potentially generate higher returns than passive investing, if the fund manager can successfully outperform the index. Active investing can also provide more diversification and customisation, as the fund manager can invest in different sectors, themes, and styles, and tailor the portfolio to the investor’s preferences and goals.
  • Cons of active investing: Active investing can also result in lower returns than passive investing, if the fund manager fails to beat the benchmark index. Active investing can also entail higher fees, as the expense ratio and the capital gains tax can erode the returns of the fund.
  • Pros of passive investing: Passive investing aims to offer consistent and stable returns, as it tracks the performance of the index.
  • Cons of passive investing: Passive investing can also limit the returns, as it cannot outperform the index. Passive investing can also lack diversification and customisation, as the portfolio is restricted to the securities and weightages of the index, and cannot be adjusted to the investor’s needs and objectives.

Considerations before investing in active and passive funds

Before investing into active and passive funds, consider crucial factors to align your investments with your financial goals. First and foremost, evaluate your financial objectives and investment horizon, ensuring they align with the fund's purpose. For instance, if seeking stable returns within a short to medium-term horizon, debt mutual funds might be a suitable option. Additionally, decide on your preferred investment mode, whether a lump sum or Systematic Investment Plan (SIP). Lump sum entails a one-time investment, while SIP involves regular fixed-amount investments at intervals. Assess your risk appetite by understanding the uncertainty of returns in relation to asset allocation, as each mutual fund scheme carries a distinct level of risk. Lastly, for passive funds, pay attention to the tracking error, the variance between the benchmark index and scheme returns, to make informed investment decisions.

Active vs. passive funds: What to choose?

The choice between active and passive funds depends on various factors, such as the investor’s risk appetite, return expectations, time horizon, and cost sensitivity. In general, active funds may be more suitable for investors who are willing to take higher risks, seek higher returns, have a longer time horizon, and can afford higher fees. Passive funds may be more suitable for investors who prefer comparatively lower risks, are satisfied with market returns, have a shorter time horizon, and are conscious of lower fees.

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Frequently asked questions

What is passive investing?

Passive investing is a strategy of investing in funds that track a market index, such as Nifty or Sensex, and aim to deliver returns like the index.

How to invest in passive mutual funds?

To invest in passive mutual funds, you can choose from various types of funds, such as index funds, exchange-traded funds (ETFs), fund of funds (FoFs), or smart beta funds, depending on your risk appetite, investment horizon, and financial goals. You can buy and sell these funds through online platforms, brokers, or fund houses.

Are mutual funds actively or passively managed funds?

Mutual funds may be actively or passively managed. Active funds have a fund manager who selects stocks and bonds to buy and sell, while passive funds follow a benchmark index and replicate its performance.

What makes actively managed funds attractive to investors?

Actively managed funds are attractive to investors who seek higher returns than the market and want to benefit from the expertise and research of the fund manager. Active funds may also provide better capital protection in turbulent markets by adjusting the portfolio accordingly.

Are actively managed funds worth the risk?

Actively managed funds are worth the risk if the fund manager can consistently beat the benchmark and generate alpha (excess returns) for the investors. However, this is not easy to achieve and depends on various factors, such as the fund manager’s skill, market conditions, fund size, and expenses.

Is passive investing cheaper than active investing?

Passive investing is cheaper than active investing because passive funds have lower expense ratios and transaction costs than active funds. This is because passive funds do not require active buying and selling of securities or extensive research and analysis.

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