We often hear about Active and Passive Mutual Funds. In this blog let’s understand the difference between them.
There are two ways in which investments in Mutual Funds can be managed. These are “Active and Passive”. When we invest in Mutual Funds, a Fund Manager buys assets such as Equity, Debt, Gold as per the Fund’s objective on our behalf of us.
In simple terms, the fund is called ‘Actively managed’ when a fund manager has more involvement in the decision-making. He is more active in looking after the selection of stocks and bonds in a mutual fund portfolio. In Active Mutual Funds, the decisions regarding selection, entry, exit, allocation of assets are being taken by a Fund Manager.
It is exactly the opposite in the case of Passively Managed Mutual Funds. Here a Fund Manager cannot decide the selection of underlying assets.
So the biggest difference between the Actively Managed and Passively Managed Mutual fund is “Decision Making of a Fund Manager”.
Actively Managed Portfolio:
Let’s understand Actively Managed Mutual Funds with the help of examples.
Following are the Actively Managed Mutual Funds
- Equity Mutual Fund (Large-Cap, Mid-Cap, Small-Cap, Flexi-Cap, etc.),
- Debt Mutual Funds,
- Hybrid Mutual Funds,
- Fund of Funds,
- Equity Linked Savings Scheme (ELSS Funds) etc.
Let’s take the example of Equity Fund. A Fund Manager of Large Cap Equity Fund will select the stocks as per specific Capitalization, he will research the valuations, financials, risk, business model, the growth potential of a company & sector. Then he will select some of the stocks. In the same manner, he will decide when to exit from a particular stock according to the market scenario and other better opportunities in the market.
A Fund Manager can also change the proportion of a particular stock in the Fund. For example, if the weight of HDFC Bank is 5% of the total assets, he can increase and decrease the same in order to deliver better returns.
Passively Managed Portfolio:
Now, it’s time to learn more about Passively Managed Mutual Funds with the help of examples.
There are two types of Passive Investing,
- Index Mutual Funds
- Exchange-Traded Funds
Both of these options are a mirror of a particular Index.
In ETFs or Index Mutual Funds, the fund manager tracks the movement of an underlying index. Stock selection & proportion of stocks is also the same as per index in the Index mutual fund or ETF.
The performance of Index Mutual Fund or ETF depends on the Index. If an Index performs well, investment performance would get better and vice versa. What goes in and out of the index is not at the discretion of fund managers. SEBI (Securities and Exchange Board of India) decides which stock to include and exclude from the index based on the performance and other several factors.
There are two popular Indexes in Indian Market. One is Sensex (consists of 30 stocks) and the other one is NIFTY (consists 50 stocks).
So, HDFC Index Fund Sensex Plan is the index Mutual fund that tracks the performance of Sensex.
ICICI Prudential Nifty Index Plan is the index Mutual fund that tracks the performance of Nifty.
What is the difference between an ETF and an index fund? ETFs can be traded (bought and sold) during the day whereas index funds can only be traded at the particular price point at the end of the trading day.
In Passive investing, the fund manager is just expected to track the benchmark and deliver the returns according to the Index performance.
Active v/s Passively Investing: Which is better?
Both strategies are unique in their own ways. Let’s look at their pros and cons.
Actively Managed Funds
- Returns: The purpose of Actively Managed Mutual Funds is to deliver better returns than its benchmark. That extra return over benchmark is called ‘Alpha’. If the Fund Manager is utilizing his skills, knowledge, and experience in investing, then it is expected to generate more returns. If you want better returns, then Active investing is for you.
- Cost: It is obvious that if a Fund Manager is doing his research and generating better returns, then it must be costlier. Every good thing in life has a cost and so is the capability of a fund manager. The expense ratio in Actively managed mutual funds is on the higher side for the fund manager’s decision-making skills.
- Risk: As these funds tend to generate higher returns, hence the risk involved with them is also higher. This is because man-made decision-making processes may go wrong.
Passively Managed Funds
- Low Cost: Expense ratios of Index Mutual Funds are much lower than active funds. According to the regulations of SEBI, the expense ratio for ETFs or Index Mutual Funds cannot exceed 1%. For example expense ratio of the HDFC Index Fund Sensex Plan (Regular) is just 0.40% (as on 28.02.2022).
- Lower Returns: Index Mutual Funds cannot beat benchmarks. These funds generate moderate returns. Returns may be equal to its benchmark’s returns or lesser. They may be cheaper but do carry some other charges which may lower the fund’s returns marginally.
Passive investing v/s Active investing:
|Strategy||The fund manager actively takes decisions about the fund’s composition at his own discretion. Utilizes his expertise.||Fund managers need to mimic the movement of the benchmark index.|
|Cost||0.08% to 2.25% depending on equity/debt orientation.||Maximum 1%|
|Returns||Fund manager aims and is often able to beat the benchmark||Equal or lower returns than the benchmark.|
Let’s compare the returns of Index, Index Mutual Fund and a Large-Cap Mutual Fund,
|HDFC Index Fund Sensex Plan (Regular)||Axis Bluechip Fund (Large-Cap)|
|Trailing returns in the last 5 years||
This question has no straightforward answer as no categories are bad. These are different investment strategies. It all depends on the investor profile.
If an investor is looking for active management, wants better returns, and is ready to take risks, should go with the active funds. However, you are investing for the long term, let’s say for 10 years and above, the risk in Active funds will be on the lower side.
On the other hand, if an investor does not want the fund manager to take too many decisions, wants the fund to simply track the benchmark, and does not want risk and complications, then passively managed funds could be considered. For beginners, Index Funds are a good choice.