Mutual fund portfolios can be actively managed or passively managed. When we say portfolio management, we mean how the underlying assets(equity, debt, gold, etc) are being bought and sold by the fund manager.
An actively managed fund means a fund manager has more involvement in the decision making, is more active in looking after which stocks and bonds go in and out of a mutual fund portfolio and when. In passively managed funds, the fund manager cannot decide the movement of the underlying assets.
While this is the main difference between active and passive investment strategies, let’s look at more differences to get a deeper understanding.
Like in the case of an equity fund, there is a dedicated fund manager who decides which stocks will go in and out of an equity fund according to the performance of the larger markets and economies and the individual performance of the stocks.
The fund manager also needs to decide if the existing stocks will remain in the same concentration if the funds invested in individual stocks need to be increased or decreased.
In other words, a fund manager has a lot to do with an equity fund’s performance. Well, we took the example of an equity fund. The case is the same for all other fund categories in the active management category.
We will understand passive investing too with the help of an example. Exchange-Traded Funds (ETFs) are passively managed funds. In ETFs, the fund maps the movement of an index and that’s all the fund does. Since what goes in and out of the index is not at the discretion of fund managers but Sebi (Securities and Exchange Board of India), the fund just directly maps the movement of the index. The returns of the index are translated into the returns that ETFs make. Differences could be due to expense ratio charges, management fees, or any other fees or dividends.
Like the HDFC Sensex ETF, it has all the stocks in the same proportion as Sensex has it. What its fund manager will do is make minor changes in the index so that the fund is in line with Sensex. Say if Sensex goes through a rejig, the fund manager will have to make the same adjustment in his/her fund. In Passive Portfolio Management, the fund manager is just expected to ape the benchmark’s performance.
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There are two other ways in which different types of mutual funds can be categorised:
Passive and active investment strategies are unique in their own ways. Let’s look at the pros and cons of both actively and passively managed funds
Alpha generating funds: If the investor wants a bit extra than what the benchmarks are offering, then actively managed funds are better. The main objective of actively managed funds is to beat the returns of the Sensex and Nifty and generate ‘alpha’. Here the fund manager uses his/her experience, knowledge, and time for market research.
Expensive: Naturally every good thing in life comes at a cost and so is the expertise of a fund manager. Investors will have to pay charges (namely expense ratios) for the fund manager’s expertise and decision-making.
Risk: Actively managed funds seek to generate higher returns and hence the risk associated with them is also higher than passive funds. This is because man-made decision-making processes may be prone to error.
Cheaper: Their expense ratios are way lower than active funds. According to Sebi regulations, the expense ratio for ETFs cannot exceed 1%. The expense ratio for the earlier example we took, the HDFC Sensex Fund is hardly 0.05% as of May 11.
Cannot beat benchmarks: Such funds have moderate returns. Returns may be equal to the benchmark’s returns or lesser. They may be cheaper but do carry some charges which may lower the returns but marginally.
|Sr. No.||Particulars||Active investing||Passive investing|
|1.||Strategy||Fund manager actively changes the fund’s composition at his/her own discretion||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||Fund manager aims and is often able to beat the benchmark||In the range of or lower to the returns of the benchmark|
It is not easy to decide which of these categories are ‘good’ or bad; because the difference between active and passive investment strategy is more a difference between its features rather than which category is good or bad. It all depends on the investor profile. The fact that an ETF directly maps an index is a passively managed fund’s feature. If an investor is looking for active management, can financially afford an active fund, and the risks and goals are in line then active funds could be considered. However, if an investor does not want the fund manager to take too many decisions, wants the fund to simply map the benchmark, and does not want to take a risk, then passively managed funds could be considered.