Category : Investing Guides January 31, 20255 minutes read
While analysing investment options, investors may compare active funds vs passive mutual funds in India. Active funds are managed by professionals who actively select and adjust the fund’s portfolio to potentially outperform the underlying index. Contrarily, passive funds passively track an underlying index and aim to simply replicate its returns.
The key difference between active funds and passive funds lies in their investment strategy. Active funds can be beneficial for investors as they may generate higher returns and give fund managers some flexibility in asset allocation, allowing them to potentially outperform market indices. However, they have higher expense ratios and may be vulnerable to market timing risk.
Passive funds generally have a lower expense ratio and a lower risk of bias, making them beneficial for investors. However, they may have a limited growth potential and allow fund managers a lack of flexibility. Lastly, they may also be vulnerable to concentration risk and tracking errors.
Introduction
Active funds are an investment vehicle managed by professional fund managers who actively select and adjust the fund’s portfolio. This management may depend on market conditions or the fund’s investment strategy.
Passive funds track an underlying index such as the Nifty 50, Nifty 100, Nifty 250, etc. These funds replicate the asset allocation and potential returns of their index. Generally, index funds and Exchange-Traded Funds (ETFs) follow a passive investment strategy.
In this article, we will explore the meaning of active and passive funds. We will also compare the benefits of active funds vs passive funds. Some benefits of active funds include their potential to generate higher returns, more flexibility, and the ability to outperform their underlying index. However, they may have certain limitations including higher associated costs, risk of bias, and market timing risk. We will also look at the benefits of passive funds such as lower expense ratio and lower risk of bias. Furthermore, we will explore the drawbacks of passive mutual funds such as limited growth potential, lack of flexibility, and vulnerability to concentration risk and tracking errors.
To further understand and compare active funds vs passive funds, it is necessary to explore the meaning and functioning of active funds in India.
Active mutual funds follow an active and dynamic investment strategy, wherein the fund’s asset allocation may be changed based on market conditions and the overall investment strategy. Due to their dynamic nature, active funds generally aim to outperform their underlying index, enabling investors to potentially benefit from changes in market conditions.
In an active fund, the fund manager conducts an in-depth analysis of market trends, economic conditions, and individual securities to build and adjust the portfolio and potentially capitalise on opportunities while minimising risk. The performance of the fund is analysed and the fund manager may adjust the asset allocation to meet the fund’s investment goals.
Active funds may invest in a variety of securities and may often be suitable for diversification. For instance, flexi cap funds in India follow an active and dynamic investment strategy wherein they may change their asset allocation as per market conditions while adhering to the mandate of investing a minimum of 65% of their corpus in equities belonging to small, mid, or large-cap stocks.
Similarly, multi-cap funds are another type of active mutual fund that can adjust their portfolio as per the investment strategy and market conditions while allocating a minimum of 25% of their corpus to small, mid, and large-cap stocks each. These dynamic investment strategies are a key difference between active and passive mutual funds.
Business cycle funds are another type of active mutual fund that adjusts its portfolio based on market cycles. Market cycles can significantly affect the fund’s performance, and through active management, business cycle funds aim to provide investors with better risk-adjusted returns.
Benefits of Active Funds
Investing in active mutual funds can have several advantages for investors. They have the potential to give higher returns and maybe a flexible investment option. Moreover, they have the ability to outperform in down markets. Let’s explore the benefits of active funds in detail.
Potential High Returns
Active funds follow a dynamic investment strategy wherein, the fund’s allocation may be changed based on market conditions. This dynamic asset allocation may enable funds to outperform the underlying index and potentially provide better risk-adjusted returns. Although active funds have a higher level of risk associated with them, they have the potential to generate higher returns.
Flexibility
By investing in active funds investors can adopt an investment strategy suited to their portfolio. Although investors cannot alter the fund’s asset allocation, they can invest in funds that specifically meet their needs. Contrarily, passive funds invest in one underlying index and investors cannot diversify their investment strategy.
Ability to Outperform in Down Markets
One significant difference to consider when comparing active funds vs passive funds is the ability of active funds to outperform in down markets. The fund managers have the freedom and flexibility to revise the asset allocation as per market conditions as long as it is within the fund mandate. As a result, during down markets fund managers may incorporate hedging strategies to reduce the impact of market volatility.
Similarly, fund managers may selectively pick stocks that perform well in down markets such as consumer staples and utilities.
Drawbacks of Active Funds
Despite the several benefits, active funds may have some drawbacks including higher cost, risk of bias, and vulnerability to market timing risk. Let’s explore these in detail.
Higher Cost
Due to the active management involved, active funds may generally have higher expense ratios to compensate for the fund’s management. This higher cost may eat into the fund’s potential returns.
Risk of Bias
Active funds generally follow some sort of investment strategy. These strategies may be subject to bias and may not always deliver the expected results. Returns from no mutual fund are guaranteed and investors must consider the risk of bias before investing.
Market Timing Risk
Some active funds such as business cycle funds and dynamic asset allocation funds may alter their asset allocation based on market conditions. There is always a risk associated when predicting market movements as equities are generally subject to fluctuations. For instance, selling assets too early in anticipation of a downturn or missing a market rally by staying overly cautious can erode potential gains.
Adopt an active investment strategy by investing in mutual funds with a dynamic investment strategy today!
Active funds in India employ a dynamic investment strategy, allowing fund managers to adjust asset allocations based on market conditions and economic trends. These funds aim to outperform their underlying index, potentially offering higher returns and potentially better risk management. Examples include flexi-cap, multi-cap, and business cycle funds, each with unique mandates for diversification and dynamic portfolio adjustments. Active funds offer flexibility, the potential for higher returns, and the ability to perform well in down markets through strategies like hedging and selective stock picking. However, they come with drawbacks such as higher costs, risks of bias, and vulnerability to market timing errors, which may impact overall returns.
Passive funds are an investment scheme that track an underlying market index such as the Nifty 50, Nifty 100, Nifty 250, etc. and aim to replicate its returns. These funds follow a passive investment strategy and aim to potentially generate returns in the long run. These funds do not aim to outperform the market index and only adjust their holdings based on the changes within the index.
For example, Nifty 50 index funds are a type of passive investment scheme that invest in components of the Nifty 50 index. This index represents the top 50 companies listed on India’s stock exchange. Nifty 50 index funds and ETFs maintain the same proportion as it is in the index. For example, if company A makes up 20% of the Nifty 50 index, the fund will allocate 20% of its portfolio to company A.
Benefits of Passive Funds
To further compare active funds vs passive funds, we need to explore the benefits of investing in passive funds. These benefits may include a lower expense ratio, lower risk of bias, and consistent market exposure. Let’s explore them in detail below:
Lower Expense Ratio
A passive investment strategy requires minimal involvement of the fund manager and AMC as the scheme is simply tracking an underlying index. Although re-allocation of assets may be required when there are changes within the index, the cost required to run the fund is generally lesser. As a result, passive funds generally have a lower expense ratio and may be beneficial for investors seeking lesser added costs.
Read more about expense ratio in mutual funds.
Lower Risk of Bias
While active mutual funds actively change their asset allocation based on market conditions, the composition of index funds remains the same, as per the underlying market index. There is minimal investment of the fund manager or AMC in determining the sectors, stocks, or market caps the passive fund will invest in. As a result, there is a lower risk of bias. Nevertheless, the passive allocation may impact returns and the fund is less likely to outperform the index.
Consistent Market Exposure
Passive mutual funds allow investors to get exposure across the market. For instance, by investing in a Nifty 50 fund, investors can get exposure to stocks of companies from several different sectors. This diversification may help reduce risk and potentially increase returns in the long-run.
Drawbacks of Passive Funds
Despite their benefits, passive funds come with certain drawbacks such as a limited growth potential, lack of flexibility, and vulnerability to concentration risk and tracking errors. Let’s compare active funds vs passive funds by further exploring these drawbacks.
Limited Growth Potential
Passive funds merely track the underlying index in a fund. They do not aim to outperform the index but replicate its returns. As a result, such schemes may have limited growth potential and inventors can expect lesser growth.
Lack of Flexibility
Fund managers of passive mutual funds do not have a lot of flexibility in terms of asset allocation. They are required to follow the underlying index and cannot adjust the portfolio as per market conditions. This lack of flexibility may prevent fund managers from taking preventive measures to hedge inflation or tackle market volatility.
Concentration Risk and Tracking Errors
All index funds and ETFs that track an underlying index are subject to concentration risk as they invest in a single index. For instance, investing in Nifty 50 index funds or ETFs gives investors exposure only to large cap companies. Thus, they may be subject to concentration risk.
Read about the types of investment risks.
Similarly, all index funds and ETFs are subject to tracking errors. Tracking errors refer to the difference between the returns of an index and the returns of a fund tracking the underlying index.
Unlock the benefits of a passive investment strategy by starting an SIP in index funds or ETFs today.
Passive funds in India track underlying market indices, such as the Nifty 50 or Nifty 100, and aim to replicate their returns without attempting to outperform them. These funds follow a passive investment strategy, adjusting holdings only when index components change. For example, Nifty 50 index funds invest in the same proportion as the index's components, offering consistent market exposure. Passive funds have benefits like lower expense ratios, reduced risk of bias, and broad diversification. However, they face drawbacks such as limited growth potential, lack of flexibility to adapt to market changes, and vulnerability to concentration risk and tracking errors.
| Parameters | Active Funds | Passive Funds |
| Meaning | Active funds follow an active and dynamic investment strategy and change their portfolio allocation based on market conditions and fund strategy. | Passive funds aim to passively track an underlying index and replicate its returns. |
| Risk | Active funds may be subject to the risk of bias and market timing risk. | Passive funds may be subject to concentration risk and tracking errors. |
| Expense Ratio | Active funds generally have higher expense ratios. | Passive funds generally have lower expense ratios. |
| Flexibility | The fund management has the flexibility to alter portfolio allocation in active funds. | The fund management has relatively less flexibility to adjust portfolio allocation in passive funds. |
- While analysing investment options, investors may compare active funds vs passive funds in India. To better understand which investment scheme is suitable, investors must analyse the key differences between active funds and passive mutual funds.
- Active funds are managed by professionals who actively select and adjust the fund’s portfolio with a goal to potentially outperform the underlying index.
- Contrarily, passive funds passively track an underlying index and aim to simply replicate its returns.
- Active funds can be beneficial for investors as they may generate higher returns and give fund managers some flexibility in asset allocation, allowing them to potentially outperform market indices. However, they have higher expense ratios and may be vulnerable to market timing risk.
- Passive funds generally have a lower expense ratio and a lower risk of bias, making them beneficial for investors. However, they may have a limited growth potential and allow fund managers a lack of flexibility. Lastly, they may also be vulnerable to concentration risk and tracking errors.
