Investors looking to diversify their portfolio can consider mutual funds. Mutual funds offer good returns but have a risk element. Due to market volatility and dependent conditions, you can expect a roller-coaster investment journey. That means a fund or index’s past performance cannot be considered a future indicator of its performance. However, this does not mean you need to shy away from investing.
You can get good returns on your mutual funds by managing the associated risks. For instance, you should be aware of how to invest for maximum gains at minimum risk. Active and passive investing are two investing types that you can apply to get the best from your investments.
Both types compare gains across common benchmark indices. Actively managed funds follow a direct investing approach. A passively managed fund tries to follow the performance of a specific benchmark index.
Continue reading this article to understand the differences between actively and passively managed funds and to evaluate the best strategy for you to achieve your investment goals.
What are Actively Managed Funds?
Actively managed funds are funds that are directly managed by dedicated fund managers with expertise in market analysis and research. The active investing strategy aims at gaining revenue by outperforming certain index returns or benchmark indices through frequent trading.
Equity funds, debt, and hybrid mutual funds are popular examples of active funds. You can undertake active investing yourself or through professionals via actively managed funds and active exchange-traded funds (ETFs).
What are Passively Managed Funds?
Passive funds are not actively managed by a fund manager. They are managed to follow the performance of a standard index to maximize returns.
For example, the passive fund- Nifty BeES tracks the benchmark Nifty 50 Index to duplicate the benchmark's performance and translate it into returns. ETFs and index funds are common passively managed funds. ETFs are funds that aim to duplicate the pattern of a particular stock index.
What is Benchmark?
Benchmark refers to an index/standard for measuring the overall performance of a mutual fund. The benchmark provides information on how much your investment should have earned compared to actual returns earned. BSE Sensex and NSE Nifty are the two benchmark indices in the Indian stock markets. Normally, a mutual fund house decides a certain fund's benchmark index. In an ideal market scenario, mutual funds should try to match their benchmark returns.
How Do Actively Managed Funds Work?
For actively managed funds, the fund managers take all relevant decisions regarding the underlying securities to generate revenue by beating a particular benchmark index.
Such decisions include tracking the market performance, individual stock performance, analyzing your portfolio investments, and so on.
So, there is a lot of detailed market research and analysis required before selecting the desired stock holdings. A fund manager frequently trades in active funds to generate the maximum return on your portfolio investment.
How Does a Passively Managed Fund Work?
A passively managed fund works on purchasing and holding securities through various market conditions to achieve the desired returns over the long term. There is no active decision-making involved. A passive fund manager attempts to follow the performance of passive funds like ETFs and Index Funds against benchmark indices. Minimal trading is conducted to generate maximum long-term returns.
If the benchmark index changes, the passive fund manager makes adjustments accordingly. They realign your passive funds to follow the performance of the benchmark index. Such fund realignment could include purchasing or selling stocks to match the revised benchmark index performance.
Differences Between Actively Managed Funds and Passively Managed Funds
Parameters | Active Funds | Passive Funds |
Management Style | 1. The fund manager has the right to select and time trades, including buying, holding, selling, and weighing the investments 2. Fund managers undertake active and detailed research and look for various investments opportunities before investing | 1. Passive fund managers are not actively involved. 2. Passive fund managers buy and hold securities relevant to a benchmark index like the Nifty 50 Index |
Performance Objective | 1. Beating the benchmark index is the main performance goal 2. Actively managed funds attempt to beat a broad market index like BSE Sensex and NSE Nifty to maximize returns | 1. Following the performance of the benchmark index is the main performance goal 2. Passively managed funds only attempt to match the benchmark index performance (fewer fees) and not beat it 3. A passively managed fund would try to imitate the performance of its benchmark index less the management fees |
Returns | Could generate higher returns over the short-term passive | Passive investing gives higher average returns with lowers costs over the long term |
Costs | 1. Active funds have higher expense ratios than passive funds 2. Actively managed funds require more in-depth research, analysis, and trading than passive funds | 1. Passive funds are cheaper compared to active funds as they have few transactions 2. Passive investing does not require in-depth market analysis daily as it tries to replicate a benchmark index to optimise returns over time. So, fewer transactions lead to lower costs. |
Risk | 1. Riskier than passive funds 2. Actively managed funds focus on individual securities 3. Active funds like equity funds try to beat the benchmark index in a volatile market, so the chances of returns and risk are high. | 1. Less risky compared to active investing 2. Passive investing strategies focus on the overall fund performance 3. You can easily diversify your portfolio across a wide range of stocks and bonds like index funds and ETFs 4. A diversified portfolio reduces the risk of loss |
Transparency | 1. Active funds are less transparent than passive funds 2. Fund managers do not disclose their investment approach owing to competition 3. Investors cannot know how their money is invested | 1. Passive investing is more transparent than active investing 2. An index gets tracked against its benchmark index. 3. Investors can track the fund's performance |
Tax Efficiency | 1. They are less tax efficient than passively managed funds 2. Actively managed funds involve higher buying and selling transactions in the fund. 3. Thus, they generate higher capital gain distributions meaning more capital gain tax to be paid by investors | 1. More tax efficient than actively managed funds 2. Passive investing involves fewer trading transactions within the index fund 3. So, fewer capital gains are generated, leading to less tax on capital gains for investors |
Which are Better—Actively Funds or Passive Funds?
There is no one best investment strategy. It all depends on the investor’s goals, funds available, tenure, and risk appetite. If you have a high-risk appetite and want higher returns over the short term, you could consider actively managed funds. However, as all mutual funds are subject to market risk, there are no guaranteed returns.
If you prefer low-risk investments with a long-term investment horizon, then a passively managed fund would be the right strategy for you. You could also consider both investment strategies.
Signing Off
Both actively and passively managed funds aim to maximise investor returns. However, they differ in certain respects. For instance, a passively managed fund offers safety and diversification, while actively managed funds may generate higher returns over the short term. Based on your investment goals, risk-taking, commitment, and investment horizon, you could select between the two strategies.
Note: The content in this article is not a piece of financial advice. Please consult your financial advisor before making any investment decisions.
FAQs
1. Are mutual funds actively or passively managed funds?
Mutual funds can be both passively and actively managed.
2. What makes actively managed funds attractive to investors?
Investors invest in actively managed funds for their potential to beat their benchmark. Also, actively managed funds have key strategies to complement your portfolio’s index funds, thus maximising your returns.
3. Are actively managed funds worth the risk?
Actively managed funds are ideal for investors who want high returns from their investments, as active fund managers try to invest in funds that can beat their benchmarks.
4. Is passive investing cheaper than active investing?
In a passively managed fund, the fund managers do not decide which securities to invest in. In active investing, a fund manager has to undertake in-depth research and analyse opportunities before investing in funds involving costs. So, passive investing is cheaper than active investing.
