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Active vs. Passive Mutual Funds: Benefits & Differences

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Created on
August 3, 2022

Summary

What’s Inside

Mutual funds have gained popularity over the last decade and rightly too. They provide investors with access to a diversified portfolio without having to worry about having market knowledge. This is owed to the fact that these funds are professionally managed. This management can see itself represented under active and passive funds. Let's have a closer look at this

What are active and passive funds?

An actively managed fund is created around a theme, and the funds invested are similar to the theme. Example, equity or debt funds. The fund manager is actively involved in the buying and selling of assets in these funds and aims to generate returns that will beat the market index.

In the case of passive funds, the funds look to generate returns similar to those of an index like SENSEX or Nifty or other indices. The composition of assets in these funds is also such that they perform at a similar level, and the fund manager is not actively involved in managing the fund. Hence, the resources required to manage these funds are lesser compared to active funds. Examples of these can be index funds or ETFs.

Comparing the two

Before we delve into the differences between active funds vs passive funds, you should note that overlaps are common between these funds across the following parameters.

Active vs Passive Funds – Tabulating the Differences 

The table below shows how actively managed mutual funds differ from passively managed mutual funds.

Differences

Area of Consideration

Actively Managed Mutual Funds

Passively Managed Mutual Funds

Cost

These funds ordinarily generate higher costs than passive funds outlined under the expense ratio. This is because this management style requires more analysis, research and trading in contrast to passive funds.

The expense ratio of these funds is comparatively lower than active funds since the fund manager doesn’t need to select securities other than the ones mentioned on the index being followed.

Definition 

These funds are created around a theme. 

These funds are designed to mimic an index like SENSEX, NIFTY or alternative indices.

Expense Ratio

The expense ratio of active funds ranges between 0.5 to 2.5 per cent depending on the composition of equity or debt.

The expense ratio of passive funds doesn’t exceed 1.25 per cent.

Management

Fund managers are responsible for sifting through and selecting underlying securities to buy keeping in mind the market scenario, the theme and the common objective.

Here, since the fund simply tracks a market index, the fund manager need not manage the fund with regularity. 

Performance Goal

Fund managers of active funds seek to surpass the performance of the broad market index i.e., the benchmark.

Here, the fund manager seeks to replicate, if not match the performance of the market index.

Strategy of the Fund Manager

The fund manager actively manages the fund keeping in mind the objective of the fund.

The fund manager’s strategy for this fund only relates to copying the movement of the benchmark indices.

Tax Efficiency

As these funds tend to have a higher turnover, they are more likely to generate greater capital gains distributions to shareholders in comparison to passively managed funds.

The capital gains distributions to shareholders tend to be lower in comparison to actively managed funds. 

Listing the Merits and De-merits of Actively Managed Funds

Actively managed funds bring with them the following advantages -

1. Professional Management

These funds spare investors the hassle of analysing, researching, selecting and buying investments of their own. Professional fund managers and their researchers do the heavy lifting on your behalf. 

2. Potential for more returns

These funds often wish to surpass broad market indexes. While there are greater risks involved, shareholders stand the potential to accrue greater returns in contrast to an index.

Apart from these benefits, these funds carry with them the following shortfalls. 

1. Expensive

The expense ratios tethered to these funds are greater, and they may expect investors to pay sales charges. 

2. Management Risk

It is possible for fund managers to be influenced by human biases and errors, which can result in them making poor decisions.

Listing the Merits and De-merits of Passively Managed Funds

Passively managed funds bring with them the following advantages.

1. Affordable

The operating costs of these funds are lower, leading to lower expense ratios. This means investors get to keep a greater amount of the funds returns which is advantageous.

2. Tax Efficient

Since these funds have a lower turnover, they incur few capital gains distributions.

Apart from these benefits, these funds carry with them the following shortfalls. 

1. Limited Flexibility

These funds only hold the securities mentioned under a benchmark index, making it unlikely for shareholders to see returns that exceed the index. 

2. Weighted Methodology

Weighting methodologies employed by these funds can result in a lower degree of diversification. It also increases the volatility the portfolio experiences via minority holdings. 

Final Thoughts

All mutual funds are subject to market risks. Always assess your own investor profile first and understand the time you are willing to devote to a fund and the money you are willing to risk. Certain funds like equity-linked saving schemes (ELSS) have a 3-year lock-in period where you cannot withdraw funds before the lock-in period ends. So, make sure you’re aware of these pointers and other details about the funds.

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Frequently Asked Questions

1. How many actively managed funds beat the market? 

As per reports, in 2021, more than 60% of the actively managed funds in India were able to beat the benchmarks. Further, it is stated that from 2009 to 2018, an actively managed fund generated an excess of 3% returns annually, which is the highest globally.

2. Are ETFs active or passive? 

Although most exchange-traded funds (or ETFs) are passive, not all are. 

3. Is it better to be an active or passive investor?

Since active managing is more expensive, a number of active managers aren’t able to beat the index after their expenses have been accounted for. Owing to this very fact, passive investing has often surpassed active investing due to the lower fees involved. However, it also depends on the risk you want to take. Many active funds have beaten the benchmark but they come at higher risks. So, in short, it depends on your risk profile and investment style.

4. What is an example of a passive investment?

An example of a passive investment is investing in an index fund that aims to replicate the performance of a specific market index, such as the S&P 500. In this approach, the fund manager does not actively pick individual stocks but instead holds a diversified portfolio of stocks in the same proportion as the index. The goal is to achieve returns similar to the overall market's performance rather than outperforming it through active stock selection.

Disclaimer

Investment and securities are subject to market risks. Please read all the related documents carefully before investing. The contents of this article are for informational purposes only, and not to be taken as a recommendation to buy or sell securities, mutual funds, or any other financial products.
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