Active Funds vs Passive Funds: What is the difference, and which one can be good for you?

Active Funds vs Passive Funds: With economic uncertainty looming, investors are seeking strategies to navigate the ever-changing financial landscape. Two prominent investment approaches are active funds and passive funds. But what exactly distinguishes them, and which might be a better choice for you? Know here what the expert says.

What are Active Funds?

Active funds are a type of mutual fund in which a professional fund manager makes decisions about which individual stocks, bonds, or other assets to buy, sell, or hold for the fund. The goal of an active fund manager is to beat the performance of benchmark indices, such as Nifty50 and Sensex.

Active Funds: Advantages and Disadvantages

These funds have some pros and cons:

Advantages: 

• Potential for higher returns: Active funds have the potential to outperform the market, which can lead to higher returns for investors.
• Diversification: Active funds can provide diversification by investing in a variety of different assets.
• Professional management: Active funds are managed by professional investment teams that have the expertise to research and analyse different investments.

Disadvantages

• Higher fees: Active funds typically have higher fees than passive funds.
• No guarantee of outperformance: There is no guarantee that active funds will outperform the market.
• More risk: Active funds may be more risky than passive funds, as they are not guaranteed to outperform the market.

What are Passive Funds?

Passive funds are a type of mutual fund that tracks a specific market index, such as Nifty 50 or Sensex. Unlike actively managed funds, where fund managers try to outperform the market by picking individual stocks, passive funds simply aim to replicate the performance of the chosen index.

Passive Funds: Advantages and Disadvantages

Advantages:

• Lower costs: Passive funds typically have lower expense ratios than actively managed funds.
• Transparency: Passive funds track a specific index, so their holdings are transparent and publicly available. This allows investors to easily understand what they're buying and how the fund is performing.
• Tax efficiency: Passive funds tend to trade less frequently than actively managed funds, resulting in fewer capital gains distributions.
• Diversification: Passive funds offer instant diversification across a broad range of assets, reducing risk compared to individual stock picking.
• Lower risk: By following a predetermined index, passive funds avoid individual stock selection risk and the potential for human error in decision-making.
• Suitable for long-term investing: The buy-and-hold strategy inherent in passive investing aligns well with long-term investment goals.

Disadvantages:

• Market returns: Passive funds aim to match the performance of their benchmark index, so they won't outperform the market.
• Limited control: Investors don't have control over the individual holdings within a passive fund, unlike actively managed funds, where managers can make strategic decisions.
• No "alpha": Passive funds generally don't aim to generate alpha, which is the excess return beyond the market average. If you're looking for potentially higher returns, actively managed funds might be a better option.

Active Funds vs Passive Funds: Which one is right for you?

Here are some factors that can help you choose the right fund:

Investment Horizon: Long-term goals (retirement, college savings) favour passive funds for their lower volatility and consistent returns. Short-term investments might benefit from active management's potential for higher, albeit riskier, gains.

Risk Tolerance: If you have a low tolerance for market fluctuations, passive funds offer a smoother ride. However, risk-tolerant investors with an eye for outsized returns might consider actively managed funds.

Knowledge: Actively managed funds require more research and understanding of individual stocks and market trends. Passive funds are simpler to manage, making them suitable for beginners.

Active Funds vs Passive Funds: Expert insights on investing in these categories:

The financial expert advised which is good to invest in between active funds and passive funds due to the active share and expense ratio.

Arun Kumar, Head of Research and VP at FundsIndia, recommends investors gradually move from active large-cap funds to passive large-cap index funds or active large-cap biased flexi-cap funds (60-80 per cent large caps with the flexibility to increase mid/small cap allocation) for participating in the large-cap segment.

According to the expert, with just 40 per cent of their portfolio actively managed (low ‘active share’) and expense ratios 1.6 per cent higher than passive options, these funds need to outperform the market by a whopping 5-7 per cent on that active 40 per cent just to match the index.

He also explained that two factors will revisit views in the future: active shares and the expense ratio.

Active share: If the active share of Active Large Cap Funds increases above 60 per cent.

Expense ratios: If the expense ratio gap between active and passive large-cap funds reduces.