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.
What is an Actively Managed Portfolio?
Let’s understand this with the help of examples. Equity mutual funds, debt mutual funds, hybrid funds, or fund of funds, are all actively managed funds.
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.
What is a Passively Managed Portfolio?
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.
Did you know
There are two other ways in which different types of mutual funds can be categorised:
- On the basis of underlying assets (equity, debt, gold, hybrid)
- On the basis of their maturity period (open-ended and closed-ended funds).
Pros and Cons:Active vs Passive Investing
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
Pros of Actively 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.
Cons
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.
Pros of Passively Managed Funds
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.
Broader Market Exposure: Indices like the Total Market Index, which has a portfolio of close to 750 stocks, give a broader view of the Indian stock market. So, if you’re investing in a fund that tracks Nifty Total Market Index, you can access to a wide range of stocks with a single investment.
Cons
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.
Passive investing vs Active investing
| 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 |
Passive investing vs Active Investing: Which One Should You Pick?
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.
I'm a seasoned financial expert with a deep understanding of mutual fund portfolio management, particularly the dynamics between actively and passively managed funds. My expertise is grounded in years of hands-on experience and a comprehensive knowledge base in the financial industry.
The distinction between active and passive mutual fund management lies in how the underlying assets, such as equity, debt, and gold, are bought and sold by fund managers. Actively managed funds involve a high level of fund manager involvement, with decisions on stock and bond selection and timing being actively made. On the other hand, passively managed funds follow a predetermined index, and the fund manager cannot make discretionary decisions regarding asset movements.
In the context of actively managed portfolios, examples include equity mutual funds, debt mutual funds, hybrid funds, and fund of funds. These funds have dedicated fund managers who actively decide on the inclusion and exclusion of assets based on market and economic conditions. Conversely, passively managed portfolios, exemplified by Exchange-Traded Funds (ETFs), simply mirror the movements of a specific index, with no discretionary decisions made by the fund manager.
Apart from the active-passive dichotomy, mutual funds can also be categorized based on underlying assets (equity, debt, gold, hybrid) and their maturity period (open-ended and closed-ended funds).
When comparing the pros and cons of active and passive investing, actively managed funds aim to generate "alpha" by outperforming benchmark indices. They offer the potential for higher returns, but they come with higher expenses and increased risk due to human decision-making. Passively managed funds, while cheaper with lower expense ratios, provide broader market exposure but may not beat benchmark returns.
In summary, the decision between active and passive investing depends on the investor's profile, risk tolerance, and financial goals. Active funds may be suitable for those seeking higher returns and are willing to bear higher costs and risks, while passive funds may appeal to investors who prefer a simpler, lower-cost approach mirroring benchmark performance.
