Active Vs Passive Funds

At the end of the day, it all comes down to one big decision: how you want to live your life. 

Do you want to analyse and plan every single step you take in order to be prepared for all the twists and turns that life throws at you? Or do you want to live life as it comes, without planning, just going with the flow?

Why are we delving so deeply into your life choices? Because they largely determine your investment strategy. If you are a meticulous planner, then active funds may be right  for you. But if you like to take things as they come then passive funds could be the way to go. 

But before we solve your active vs passive funds dilemma… let's tell you what they are.

What are Active funds? 

As the name suggests, active funds are actively managed by a dedicated fund manager. All the buying and selling related decisions are taken care of by the fund manager while taking into consideration the short and long term dynamics of the market. These funds are built around a theme and all investments made are in line with this theme. The fund manager’s main objective is to garner returns on the funds in excess of the market index. 

Different types of Active funds

The most popular types of active funds are Equity and Debt mutual funds. Read on to learn  more about them.

Equity mutual funds

These invest your money mainly in shares and stocks of companies. Simply put, equity funds invest in equity and equity related instruments on your behalf.

Debt mutual funds

Most of the money pooled is invested in debt or fixed-income instruments. For example, if you invest in debt mutual funds, your money will be invested in  instruments such as  debentures, corporate bonds, government securities, etc. 

Advantages of Active funds

Active funds offer more than one benefit to investors. Some of them are listed below: 

Professional management

With active mutual funds, you can sit back and relax and let the fund manager do the work for you. You are spared the hassle of researching the market, analysing it, studying the trends, identifying the companies to invest in and buying them. Professional fund managers will do it all for you. 

More returns

The potential for returns are much higher  and they aim to beat the market indices. Yes, they come with a fair share of risk, but the investors stand a good chance of accruing a great return on their investment.

Risk mitigation

Fund managers are always aware of what is happening in the markets. Therefore, they actively make changes to the investment strategy based on the prevailing market conditions. To some extent, this helps in mitigating the risk and earning higher  returns.

Disadvantages of Active funds

However, like any other investment option, active mutual funds have certain disadvantages as well. Here are some of them: 

Human bias

Let’s face it, fund managers are only human. Sometimes, biases and lack of time and research can have a negative impact on investment decisions, and they can go in an unfavourable direction. 

Relatively expensive

The transaction costs of active mutual funds can be relatively high. This is because the invested fund is often realigned based on changing market scenarios.

What are Passive funds?

As promised, we will now tell you about Passive funds. Put simply, passive funds are laid-back investments. They tend to mimic indices and deliver returns accordingly. They are passively managed, which means there is no attempt to garner alpha returns, or returns that beat market indices. 

Different types of Passive funds 

There are different types of passive mutual funds available. Some of these are: 

Index funds

In these funds, the investment follows an index and the portfolio looks like an index of the stock market. In India, index funds are based on gold, Nifty, Midcap index, etc. 

ETFs

Another type of passive fund is the ETF, which stands for Exchange Traded Funds. The basic difference between Index funds and ETFs is that index funds can only be traded at the end of the trading day, while ETFs have no such restriction. ETFs can be traded at any time during the trading day. In some cases, ETFs may have lower minimum investment requirements and may  be less tax-intensive than most index funds.

Advantages of Passive funds

Now that you have a fair bit of information about passive funds and their different types, let's look at some of the benefits of investing in them. These are: 

Relatively inexpensive

Passive funds are more affordable than active mutual funds. The operating costs of passive funds are much lower. That’s because in passive funds, there is not much realignment of funds in the direction of the markets to maximise profits. Also, the role of the fund manager is limited. All these factors reduce the expense ratio of passive funds considerably. It also means that investors can keep more of the fund's returns. 

More transparent

As we have said, passive funds mimic the indices. Hence, the investment strategy for a portfolio is completely clear and there is absolute transparency.

Tax efficient

Passive funds often have a lower turnover. This helps to reduce tax liability. This  is because with lower turnover, passive funds have fewer distributions related to capital gains. 

Disadvantages of Passive funds 

Passive funds also have a few shortfalls that  should be considered while making investment decisions. Let's take a closer look.  

Low returns

The aim of all kinds of investment is to earn maximum returns. Passive funds lag behind on this parameter. The returns generated by passive funds are in line with the benchmark, so there is no scope for them to generate much alpha.

Lack of flexibility

Regardless of market conditions, Passive funds follow benchmark indices only. This can prove to be a disadvantage for the investors as these funds sometimes fail to take advantage of profitable opportunities that could potentially boost returns in a big way.

Active vs Passive funds 

Now that you know all about active funds and passive funds, it is time to answer the million dollar question. Should you invest in active funds or passive funds? Which is the best investment option for you?

Frankly, there is no cheat sheet. Each of these two options, i.e, active funds and passive funds, has its own set of pros and cons, which we have already discussed. If you are faced with choosing between the two,  here are some important factors to consider:

What is your investment goal?

Before you make any kind of investment decision, it is essential that you decide what your goal or objective is for investing your money. For example,some people invest for their life after retirement, others to fund their current expenses, others to raise money for big life events like weddings, vacations etc. Whatever your goal may be, defining it beforehand gives a structure to your investment strategy and helps you make prudent decisions when it comes to allocating your money. 

What is your risk appetite?

Investors can be categorised according to their risk appetite. Some are conservative in their approach and hence look for lower risk options. They don’t mind smaller returns on their investment, they just want to safeguard their investment from market fluctuations. But, there are aggressive investors as well, who are more likely to seek maximum or alpha returns from their investments and willing to take the risk involved. Ask yourself which type of investor you are. 

The time factor?

In the game of investment, time is  more important than timing. What does this mean?

Basically, you need to pre-decide the duration of your investment. Think thoroughly if you want to invest your money for a long term i.e. over one year, or you want a short term investment.  The duration of your investment can be decided based on the basis of your investment goal, your current income and the returns you expect from it. Typically, long term investments are better suited to meet your future needs like funding an education, post-retirement goals, etc. Short-term investments are more liquid and can be converted into cash when needed. 

An ideal investment mutual fund strategy should include both active mutual funds and passive mutual funds. This kind of portfolio will help you maximise returns while remaining cost effective. Remember, that all mutual funds are subject to market risk, so a detailed assessment of all the factors is crucial before taking the leap. 

We hope that this article successfully solves your dilemma regarding active vs passive funds. What suits you best? Let us know in the comments.