Actively Managed Funds Or Passively Managed Funds Which One Is Better

Sheela, a 35-year old operations manager, had been investing in mutual funds using an mutual fund investment app for over a decade now. Even after investing for more than 10 years, the mutual funds in which Sheela was investing weren’t able to help her get closer to her financial goals. That is when she came across index funds but was unable to understand them completely. Unfortunately, like Sheela, there are millions of other mutual fund investors who are not well versed with the features and benefits of passive funds like index funds and ETFs and hence, refrain from investing in them.

Some of you may not even know what passive funds are and how different they are from active funds. This blog aims to shed light on active and passive mutual funds. We also make an to explain the various aspects of both these funds and their investment styles. We hope that after learning the similarities and differences between active and passive funds you might be able to make an informed investment decision.

What is active and passive management?

A mutual fund can either be actively managed or passively managed. Management of a mutual fund portfolio means how the designated fund manager picks underlying securities and buys / sells or holds onto them to help the scheme generate capital appreciation. These underlying securities which construct a mutual fund portfolio may vary from stocks, bonds, commodities, and other money market instruments. The fund manager may choose these securities based on the scheme’s investment objective and devise an investment strategy accordingly.

In an actively managed mutual fund portfolio, the fund managers are the decision makers. They can decide which stock or bond to invest in, which one to sell or which one to hold on to. But in case of a passively managed fund, the fund manager may not have much participation. Now, when we say no active participation, this does not mean there is no involvement at all. Let us understand the difference between active and passive investing.

Active investing in mutual funds

To begin with, mutual fund products like equity funds, debt funds, fund of funds, hybrid funds, gold funds etc. are all categorized as actively managed funds. Let us take the example of Equity Linked Savings Scheme (ELSS) . ELSS is an equity scheme with a tax benefit and three year lock-in period. The fund manager managing this active fund is responsible for ensuring that he builds a portfolio of securities and trades these underlying securities in alignment with the changing market cycles.

The fund manager may also choose the concentration of stocks that form the portfolio and over-time decide whether these individual stocks need any absorption. The fund manager of an ELSS fund is responsible for ensuring that over the long term, the scheme is able to deliver some capital appreciation for investors.

While this example is applicable for ELSS portfolio management, the same is applicable for all other actively managed funds.

Passive investing in mutual funds

Index funds were first introduced in 1976 and are known to be the first ever mutual funds to adopt a passive investing strategy. Index funds and exchange traded funds follow a passive investment strategy. These funds are designed in such a way that they track the performance of the underlying securities of a specific benchmark with minimal tracking error. Passive funds like index funds or ETFs are supposed to generate capital appreciation by mapping a particular index. Here, the fund manager only reshuffles the portfolio from time to time. They are not actively involved in buying or selling the underlying securities to meet the investment objective. The performance of passive funds is void of human bias and human interference. All it does is map the movement of its underlying benchmark.

As per SEBI regulations, an index fund / ETF must invest a minimum of 95% of its total assets in the underlying securities of an index which it replicates for income generation.

What are features of active funds?

Active funds offer diversification

Active funds diversify their investment portfolio across asset classes, stocks of several companies, various sectors, and industries. As retail investors it might not be possible for people to invest and seek capital appreciation by individually investing in such niche markets. Mutual funds offer investors with exposure to multiple sectors through one single investment. This may be better than investing in individual securities where your finances are exposed to greater volatility.
They offer professional fund management

A lot of investors invest in mutual funds because they do not have the penchant or the resources to invest in individual securities. This is where professional fund management plays a pivotal role. To invest in direct equities is not just time consuming, it may also require the investor to keep abreast with market trends. Since most investors are salaried individuals caught up in a hectic lifestyle, they may not have enough time to gain deep understanding of how markets function.

SIP option

Investors can opt for a Systematic Investment Plan as it is an effective way to invest in active funds. They can also consider lumpsum investment but, for that, they may need to have a large investment sum. Systematic Investment Plan is probably the most convenient way to invest as it allows investors to invest small fixed sums at regular intervals. All that investors have to do is instruct their bank to allow auto-debit, decide on the monthly SIP amount and choose a date of investment. After this, every month on the predetermined date, the fixed SIP sum is debited from the investor’s savings account and electronically transferred to the fund portfolio. SIP is also known to inculcate the discipline of regular investing as you automatically save and invest a fixed sum every month. SIPs are flexible which allows investors to increase or decrease their SIP sum at no extra cost. There are no cancellation fees involved as well.

Multiple investment products to choose from

Under mutual funds there are a lot of subcategories. This means, more investment options for investors. Mutual funds have various investment styles and types which makes them a viable investment option for almost all types of investors. Since there are so many investment options, it gives investors an opportunity to diversify their investment portfolio across asset classes. For example, those with a high risk appetite can invest 80% of their investment sum in equity and the remaining 20% in debts. Investors looking to invest in gold can invest in gold funds to protect their capital against inflation. For those planning their retirement , such investors can opt for solution oriented schemes like retirement plans. A tax paying citizen looking for an investment option to save tax can opt for ELSS. These are just few of the examples of the products available under active mutual funds.

What are the features of passive funds?

Low management cost

Since these funds offer passive fund management, they bear a low expense ratio. The expense ratio of a passive fund will always be lower than an active fund (at least in most scenarios). As per the SEBI mandate, the expense ratio of all passive funds is capped at 1%. This means, a fund house cannot levy an expense ratio exceeding 1% on passive funds.

Passive funds offer liquidity

Some passive funds like ETF can be live traded based on their current market price throughout trading hours. Trading ETF units is similar to trading company stocks at the stock exchange. This allows investors to enter and exit ETF funds if and when necessary. Such liquidity may not be offered by active funds and investors may have to specifically place a buy / sell request to the fund house. With equity schemes like ELSS, one cannot redeem their units for at least 36 months from the date of investment as this fund comes with a statutory lock-in period of 3 years.

Free from human bias

Investors who wish to invest in a fund that has very little human involvement can invest in passive funds. These funds follow a passive investment strategy as the fund manager here is only involved in building and reshuffling the underlying securities to keep them aligned with the fund’s asset allocation strategy. Passive funds are simply designed to mimic the performance of their underlying benchmark. Some investors do not want their mutual fund investments to get affected by human emotions, especially when the markets turn volatile. Passive funds offer that investment option.

Should you invest in active funds or passive funds?

There is a lot of debate on which type of mutual fund is ideal for investment. The answer to this is subjective and may differ from investor to investor. It will be unjust to deem one of them to be ‘good’ and the other one to be ‘bad’ investment as both active and passive funds have their own pros and cons. For example, active funds offer active risk management. Passive funds have a low expense ratio. An investor who can afford a slightly high expense ratio may prefer active funds. On the contrary, someone seeking a passive investment strategy may find passive funds more suitable for their investment goals.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.