Mutual funds are the most common form of investment. Now, when it comes to mutual fund portfolios, you can manage them actively or passively. As far as portfolio management is concerned, it refers to how the fund manager buys and sells underlying assets, including debt, gold, and equity.
A fund manager is more involved in an actively managed fund in making decisions. They are also more active in determining which ones of the bonds and stocks go in and out of the mutual fund portfolio and when. However, the fund manager does not have the authority to decide the movements of the underlying assets in passively managed funds.
This is the main difference between the strategies of active and passive investing. Now, let us look into these in detail for a better understanding.
What is active investing?
It is easier to understand active investing with the help of an example. So, we will try to understand it with the example of an equity fund.
When it comes to actively managed funds, funds that fall into this category are debt mutual funds, equity mutual funds, fund of funds, and hybrid funds. Just like an equity fund, a dedicated fund manager determines the stocks that go in or out of an equity fund based on the larger markets’ performance and economies, as well as the stocks’ individual performance.
It is also the responsibility of the fund manager to determine if the existing stocks are to remain in the same concentration when the funds that are invested in individual stocks are required to be raised or lowered. So, to put it simply, the fund manager has a pretty important role in the performance of an equity fund.
We only took the example of equity funds, but the scenario is the same if you take other fund categories into account for the active investment management category.
If the investor would like to have a bit more than what is offered by the benchmarks, then it is better for them to go for actively managed funds. The key objective of active investing is beating the returns of the Sensex. The fund manager has to use their knowledge and experience for this, and they also have to devote time to market research.
The expertise of a fund manager comes at a cost. If you want to have an actively managed portfolio, then you have to pay for the expertise and decision making of the fund manager.
Risk of active investing
Actively managed funds aim to generate higher returns. Therefore, the risk associated with these is also higher than passive funds. You also need to keep in mind that it is a man-made decision-making process, and it can be prone to error.
What is passive investing?
We would use the example of Exchange Traded Funds (ETFs) to understand passively managed funds. In ETFs, all the fund does is mapping the movement of an index. What goes in and out of the index is not decided by a fund manager like actively managed funds. Instead, the securities and exchange board decides it. The returns of the index are translated into the returns made by the ETFs. The differences may depend on management fees, expense ratio charges, or other dividends or fees.
Take a Sensex ETF of a financial organization, for example. It has all stocks in the same proportion since Sensex has it. What the fund manager needs to do is make little changes in the index so the fund can be in line with Sensex. So, if Sensex goes through rejig, the fund manager will also have to make the same adjustment in their fund. When it comes to passive portfolio management, all the fund manager is expected to do is ape the performance of the benchmark.
Compared to active funds, the expense ratios are a lot lower in passive investments. It helps you save your money so you can put more capital into the investment.
Passively managed funds have moderate returns. Returns can be equivalent to the returns of the benchmark, or it can be lesser. Although they are cheaper, they carry some charges. Hence, the results can be lower marginally.
|Serial No.||Particulars||Active Investing||Passive Investing|
|1.||Strategy||A fund manager actively changes the fund’s composition at their own discretion.||A fund manager only copies the movement of the benchmark indices.|
|2.||Expense Ratio||0.08 to 2.25% depending on equity/debt orientation||Maximum 1%|
|3.||Returns||A fund manager aims and is often able to beat the benchmark.||In the range of or lower to the returns of the benchmark|
What Will You Pick – Active of Passive Investing
It is not easy to just call a category good or bad because both active and passive investment has their own advantages and disadvantages. Rather than pointing out good or bad, both categories are different due to the features. It mainly depends on the profile of the investor. As mentioned earlier, an ETF maps an index directly, which is the main feature of a passively managed fund. As an investor, if you are looking for active management, you should consider the goals as well as risks in active funds. You also have to make sure that you are able to afford an active fund financially. However, if you do not want the decisions to be taken by the fund manager and only want the fund to map the benchmark simply while avoiding risk, you should consider the passive investment.
If you want to invest in mutual funds, you can either go for active or passive investment. Based on your preferences and requirements, any of the two can be useful for you. However, you must study them better and increase your knowledge so you can avoid risk and know what you are doing. Once you understand the difference between the strategies well, you can go for the option more suitable for you.