What are active and passive mutual funds?

Introduction

Would you like a fund manager to actively manage your money or are you fine letting your investments simply track the market? Either way, you are supposed to have a good understanding of active and passive funds. The debate on passive and active funds is continuously going on in developed and developing economies. But before going into that let us first have a basic understanding about active and passive mutual funds.

Active funds

Active funds are actively managed by experienced fund managers. The main aim of an active fund manager is to pick profitable investments, targeting to execute a stock that outperforms the fund’s specified benchmark or index. Actively managed funds charge higher fees because management needs a team of researchers and analysts who do rigorous research of the markets and suggest which stocks to invest in. The advantage that investors have in active funds is that they can hedge their bets and exit the funds whenever required. There is certain amount of flexibility that active funds allow.

Passive funds

A passive fund is a type of investment vehicle that religiously tracks a market index, intending to fetch maximum gains. The fund managers are not actively engaged in investing. Rather they let the investments to track the indexes. Passive funds are easier to invest in and are best suited to investors who do not have time to do research and calculation of a fund regularly.

Passive funds are not that popular in India but gradually they are gaining popularity now as more and more people are getting aware about it.

Example

If an index fund tracks a Nifty benchmark, the fund will have the same 50 stocks that these funds are comprises of and in the same ratios. Since the fund's portfolio replicate the index, the returns from the fund will follow the index return. The fund manager will not implement any style or strategy to generate excess returns over and above the index returns. They just let the funds to chase the indices.

Another example could be Exchange Traded Funds (ETFs) that are listed and traded on stock exchanges. Interesting feature of ETFs is that they look like mutual funds but traded like stocks. These are index funds that invest in basket of securities that mostly track a certain index to mirror its returns. They have low expense ratio as they are passively managed funds. These have experienced a spectacular growth of 65% per annum over the last 10 years so we can say that their popularity has been growing in Indian markets. One more reason of their popularity is that 15% of new inflows are coming from EPFO investments. The number of ETFs has also grown in number from 36 in 2015 to 82 in 2020. The basic thing that investors should keep in mind is tracking error (to what extend the fund is replicating the index) and expense ratios. The lower the tracking error and expense ratios, the better the fund. For example- As on December 2020, SBI ETF Nifty 50 having corpus ₹ 81,194 crore with expense ratio of 0.07 is the biggest ETF in India. Additionally, SBI’s Assets Under Management (AUM) are the highest because of SBI ETF nifty 50.

There is another segment called Debt ETFs in passive funds category. NSE indices almost enjoy a virtual monopoly in debt segment, most of it attributable to Bharat Bond ETFs. Since its launch in December 2019 Bharat Bond ETFs has crossed ₹ 25,500 crore in third week of July 2020 itself. It raised around ₹ 11,000 crores for state owned companies.

After reading about active and passive funds, we can chart out a table of basic differences between these two as mentioned below:

Conclusion

Active funds are more popular in India than passive funds. There are few index funds with a very limited corpus. Indians typically prefer active funds as they have lots of options available to choose from. Active equity funds are considered a good tool to achieve long term financial goals such as wealth creation for child's education or retirement. As these funds are in the high-risk high-return category, they can fetch good returns. Many active funds have given very high returns compared to benchmark and few have also underperformed the benchmark. The key is it to identify the correct active funds which have consistently beaten the benchmark and therefore knowledge and analysis in selecting the funds is very important for investing in active funds. Also, not all the active funds will beat the benchmark all the time therefore for a timely review and switching of schemes it is recommended to go with your financial advisors. The investment decision also depends on your risk preference and investment goal. Index funds are suited for risk averse investors. These funds do not demand extensive or rigorous tracking. Investors choosing index funds should have a long-term investment horizon. The fluctuations in the short run will average out in the longer run. It is a hard task to decide which of these categories are good or bad. It all depends on the investor’s investment goals, risk tolerance etc. If an investor is having risk appetite and can afford to give management fees, then active funds are best suited for him/her. However, if an investor does not want to get into research, calculation and analysis but simply wants the fund to map the benchmark then passively managed funds are best for him/her.

Happy investing!

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