When it comes to mutual fund investing, investors can choose between actively and passively managed funds. While both aim to provide market-linked returns to the investors, these funds tend to differ on many parameters.
Active investing means the fund management team actively manages the investment portfolio and makes all the investment decisions after adequate due diligence. In contrast, passive investing indicates that the fund management team only tracks an underlying index. All the investment decisions, in this case, are based on the changes in the underlying index.
When comparing active vs passive funds with respect to investor returns, an actively managed fund will aim to generate better returns compared to the benchmark index. In contrast, passive funds aim to generate returns in line with the underlying index instead of outperforming it. Therefore, alpha generation, i.e., outperformance against the benchmark index, may not be expected from passive funds.
Investors need to manage two investment risks – systematic and unsystematic risks. Systematic risks refer to the dangers of adverse economic events leading to lower portfolio valuation. Such risks are universal to all market-linked investments. In contrast, unsystematic risks are related to making a wrong stock selection leading to losses in the investment portfolio. Since passive funds cannot step beyond the underlying index, unsystematic risks get automatically eliminated in such funds.
Actively managed investments or active funds tend to have higher portfolio turnover and higher fund management charges when compared to passive funds. As such, passive funds may provide cost-effective options to the investors, but the investors' return expectations should also be moderate from passive funds. This is because passive funds can only replicate the benchmark indices and not maintain an actively managed portfolio.
With the risk-reward trade-off between active and passive investments, investors may make an informed choice for creating their long-term investment portfolio.
Here are the broad differences between active and passive funds:
Investing strategies
An actively managed fund will follow active investment strategies, wherein professional fund managers decide the kind of securities they deem fit in the portfolio. Further, fund managers may also position size in a stock based on their conviction in the stock, generally backed by in-depth research on the stock by the analyst team.
In contrast, passively managed funds adopt a passive investment strategy. The fund will track an underlying index, such as S&P BSE Sensex (representing top 30 companies in market capitalisation), Nifty 50 (representing top 50 companies in market capitalisation) etc. A fund manager dedicated to managing the fund has a responsibility to mimic/track the underlying index as closely as possible to reduce the potential tracking error.
Discretion on stock selection
Active funds allow the fund managers to choose different stocks and their weights as per their performance outlook.
In contrast, passive fund managers cannot exercise discretion and go beyond the securities in the underlying index. They cannot change the weightage of such securities in the portfolio compared to the weightage in the underlying index.
Alpha generation
The managers of active funds endeavour to generate returns for the investors over and above the benchmark index in the long run. They will aim to generate alpha for their investors.
In contrast, the returns of the passive fund will be almost equal to the returns generated by the underlying index, subject to tracking errors and fund expenses. By their structural design, passive funds may not be expected to generate significant alpha for their investors.
Total Expense Ratio (TER)
Considering the fund management strategy adopted by actively managed funds, such funds tend to have higher fees and expense ratios than passively managed funds.
As per the guidelines on TER set by the regulator, actively managed funds are allowed to charge up to 2.25% as expenses. However, as the asset under management grows, the TER of actively managed funds reduces as per the defined slabs. On the other hand, the TER of passively managed funds is capped at 1%, which makes passive funds a low-cost vehicle within mutual fund schemes.
Investment risk
When investing in markets, the investors need to manage two kinds of risks – systematic and unsystematic. Systematic risks refer to the dangers of change in portfolio valuation due to adverse economic events, e.g., the Covid-19 outbreak, which led to a strong market correction in March 2020.
Such risks are considered universal to all market-linked investments. On the other hand, unsystematic risks may arise due to poor stock selection, leading to losses in the investment portfolio. Since active funds are involved in active investment strategies, the investors are exposed to both systematic and unsystematic risks.
In contrast, passive funds don't offer any flexibility to the fund managers to go beyond the underlying index. As such, the unsystematic risks get eliminated automatically for the investors in passive funds.
Portfolio turnover
Active funds may have a higher portfolio turnover ratio, as the fund managers aim to make operational investment decisions to generate better returns than the benchmark index. In contrast, passive funds may be expected to have a lower portfolio turnover ratio since the changes in the underlying index are not that frequent. This is because the fund manager will make the changes in the investment portfolio only when there are corresponding changes in the underlying index.
Investment options for the investors
Investors can expect to have a wider choice of mutual fund schemes that are managed actively.
While passive funds have a significant market share in mutual fund AUM (Assets Under Management) in developed economies, such funds are yet to gain traction in India.
As of June, 2022, passive funds, including index funds, exchange traded funds, and Fund of Funds investing overseas, have only an 11% share in the industry AUM with an AUM of ₹5.01 lakh crores*. Although there appears to be steady traction of such funds in India, passive funds still have a long way to go.
