What is an active fund?
An active fund is a mutual fund in which the fund manager makes decisions about what to buy, hold, and sell. The manager and the research team study companies, sectors, the economy, and market conditions. They then build the fund’s portfolio based on the fund’s investment strategy.
The goal is to perform better compared to the benchmark. For example, an active large-cap fund may use the Nifty 50 as its benchmark. The fund manager can choose different stocks, change their weights, or avoid certain stocks based on their views.
Active management means the portfolio changes more often. This also makes running the fund more expensive. Therefore, active funds generally have a higher expense ratio than passive funds.
What is a passive fund?
A passive fund is a mutual fund that, instead of picking stocks to beat the benchmark, follows a particular index. For example, a Nifty 50 index fund holds the same companies as the Nifty 50 index. So the fund’s performance stays close to the index. The fund manager still has to handle changes in the index and keep the portfolio aligned with it. But there is much less room for stock-picking decisions.
Index funds and Exchange Traded Funds (ETFs) are common examples of passive funds. Their main aim is to follow the chosen benchmark, not beat it. And since there is less active research and trading, passive funds generally have lower costs. However, you shouldn’t expect the fund to give the exact same return as the index. Expenses and tracking differences can create some gap between the two.
Active vs passive funds: Comparing the benefits
When comparing active vs passive funds, the main difference is how the portfolio is managed. While both types offer you diversification, they also offer specific benefits, such as:
Benefits of active funds
- More freedom: The fund manager isn’t restricted to investing in specific stocks or weights in an index. They can make changes when they see an opportunity.
- Chance to beat the benchmark: An active fund aims to do better than its benchmark. A good investment call can help the fund outperform.
- Can react to market changes: The portfolio can be changed when the manager believes a company, sector, or market situation has changed.
Benefits of passive funds
- Lower cost: Passive funds generally have a lower expense ratio because they need less active research and trading.
- Simple approach: You don’t need to worry about whether the fund manager will pick the right stock. It can be simpler to understand if you are a beginner.
- Easy to understand: If you know what the index represents, you have a fair idea of what the fund is designed to hold.
- Less manager-dependent: Your returns are linked mainly to the index rather than the individual decision of a fund manager.
Active vs passive funds: Comparing the risks
It would be unreasonable to say that one fund is riskier and the other is not. Both types come with their own set of risks. Let’s check them out.
Risks involved with active funds
- Manager and stock selection risk: A fund manager may make a decision that doesn’t work out. A stock that looks attractive may fall. A sector bet may also go wrong.
- Underperformance risk: An active fund can also underperform its benchmark. There are many active funds that fail to beat benchmark returns after considering costs.
Risks involved with passive funds
- Tracking error: This means the return of the fund may not perfectly match the returns given by the index. Expenses and other factors like rounding gaps or bid-ask spreads can create this difference.
- General market risk: Though passive funds don’t have stock-picking risk, they still move with the market. So if Nifty 50 falls, the Nifty 50 index fund will also fall.
So, both the funds carry risks. Only the type and source of that risk are different.
Active vs passive funds: Which one may suit you?
To decide between active vs passive funds, you should consider a few points, such as:
- Expense ratio: If keeping costs low matters to you, passive funds may be worth looking at because they generally have a lower expense ratio.
- Portfolio management: With an active fund, the manager makes decisions for the portfolio. Some are comfortable with that, while others prefer a rules-based approach.
- Financial goal: Have a clear vision about what you are investing for and how long you plan to stay invested.
- Risk level: Don’t forget that the underlying holdings matter. A passive small-cap index fund can be more volatile than a passive large-cap index fund. Choose as per your risk appetite.
- Expected performance: If an active fund is charging a higher fee, you ideally expect it to perform better than its benchmark. Check its historical data to know if it has consistently performed better.
Don’t try to find which type is universally better. See which investment style makes more sense for your own situation.
The bottom line
The whole active vs passive funds comparison comes down to how you want your money to be managed. You may prefer an active approach where a fund manager makes portfolio decisions. Or you may like the simpler idea of following a particular index and keeping costs lower.
Start with your goal, understand the fund, and check whether you’re comfortable with the risks and costs. As you learn more about investing, choosing between different fund styles will become much easier.
