What is the Difference Between Passive Funds and Active Funds?

As an investor, you may include actively managed or passively managed mutual funds, or a combination of both, in your investment portfolio. When we talk about an actively managed mutual fund, the respective fund manager is typically more involved in the decision-making process. Unlike passive funds, active funds involve more frequent rebalancing of assets. 

In passive funds, fund managers do not play an active role in deciding the ratio of the underlying assets. This type of mutual fund invests in the same assets as that of its benchmark index.  

This is the main difference between passive funds and active funds. Now, let us delve deeper to gain more knowledge about them.

What Are Active Funds?

Active funds are mutual funds where fund managers actively decide which stocks to buy and sell. They achieve this by closely analysing stock market movements and economic indicators to try and outperform the market.

You can build an actively managed portfolio by investing in a collection of active funds. In any of these funds, the goal of the fund manager remains to beat the returns generated by a benchmark index. Some of the benchmark equity indices in India include Nifty 50, BSE 200, BSE Midcap index, and so on. 

How Do Actively Managed Funds Work?

Active funds are managed by professionals who make investment decisions on which stocks to invest in. Their aim is to outperform a specific benchmark, like the Nifty 50, BSE Sensex, etc. The fund manager's role involves selecting stocks and assets while continuously analysing market trends and economic conditions. Their objective is to achieve returns that exceed the benchmark.

Fund managers work with analysts and researchers to buy and sell investments strategically. When you are selecting active funds, you should also assess the manager's long-term track record across different market conditions. However, you also need to remember that past performance is not a reliable indicator of future results.     
 

What Are Passive Funds?

Passive mutual funds try to mimic the performance of a benchmark index or commodity and are generally preferred by individuals who prioritise long-term investing.

Passively managed funds can be a passive index fund, FoF, exchange-traded funds, and ETFs. As a beginner, it is safer to invest in this type of fund as the risks of short-term volatility can be successfully averted. 

How Do Passively Managed Funds Work?

Compared to active fund investors, you need to bear a much lesser expense ratio while participating in a passively managed fund. This is because these funds do not require active management.    

Passive funds try to replicate their respective indices by investing in the same stocks in the same proportion. Instead of trying to beat the index, their aim is to provide similar returns in line with the overall market. Tracking errors can still occur in passive funds, though they tend to be lower than in active funds. 

Should You Rely on Active Fund or Passive Fund Investing?

As you understand the key differences, they will help in making a decision between a passively managed index fund and an active fund. 

Below, we have provided a table outlining the major distinctive points:

Parameter

Active Mutual Funds

Passive Mutual Funds

Goal

The objective is to outperform a benchmark index (S&P BSE Sensex, Nifty 500, BSE 200, etc.)

They aim to mimic the performance of a specific market index, sector or commodity. 

Management

Fund managers select the securities. They thoroughly analyse the market conditions and tally stocks with the fund theme and objectives before adding them to the portfolio. 

The management simply allocates shares as per the market capitalisation. 

Risk

Active funds could be riskier when compared to passive funds as the returns depend on the fund manager’s judgement, skills, and errors. 

Passive funds remove the human bias by following a rules-based approach, ensuring diversification, reducing emotional decisions, and lowering risks.

Returns

The performance of an active fund depends upon the expertise of its fund manager. Hence, the results may surpass the benchmark index during certain periods or vice versa.

Passive fund investors get market-aligned returns. As a result, they may not experience exponential alpha.

Expense Ratio

Active funds come with higher expense ratios, as the fund managers perform in-depth research, analysis, and core management.

For passive funds, participants typically get lower expense ratios as the fund managers have limited involvement.

Ultimately, your choice between an active fund or a passive index fund for SIP or Lumpsum will predominantly rely upon your investment objectives and the prevailing market conditions.

Experienced investors suggest carefully assessing personal financial situations before determining the most suitable option. To start with, you can seek professional support to help create a well-defined strategy for investments.

FAQs

1. Is it better to invest in passive funds or active?

   The choice between active and passive investments depends on the investor’s risk appetite, time horizon and return expectations. If you have a lower risk appetite, then you may go for passive funds. On the other hand, if you prefer higher risk active funds may be suitable.

2. Are active funds worth it?

   Actively managed funds hold the potential to provide market-beating returns. However, there is no guarantee of consistent outperformance. Thus, investors may weigh their expected rewards against the risks involved.

3. Which is the best SIP to invest in for good returns?

   There is no such thing as the ‘best SIP’.  The best choice depends on your risk tolerance, investment horizon, and financial goals. For passive funds, you should consider factors like the expense ratio and asset allocation. For active funds, you should also evaluate the fund manager's performance. Ultimately, your decision should align with your investment strategy and objectives.

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