Choosing between active and passive mutual funds is a dilemma that many investors face.
With the ever-evolving financial landscape, the decision is often clouded by varying opinions
and market dynamics. This constant debate can be overwhelming, especially when you
consider the potential impact on your financial future. Should you opt for the higher returns
and risks associated with active funds, or play it safe with the steady, lower-cost passive
funds? Understanding the nuances of each can help you make an informed decision that
aligns with your investment goals and risk tolerance.
What are Active Funds?
Active mutual funds are designed to outperform a benchmark index through frequent
buying and selling of assets. Managed by professional fund managers, these funds rely on
in-depth research and strategic decisions to generate higher returns. The active
management approach involves higher costs, as the expertise and effort of the fund
managers come at a premium. This is reflected in the higher expense ratios, which can eat
into the overall returns of the fund. However, the potential for substantial gains often
justifies the costs for many investors.
What are Passive Funds?
In contrast, passive mutual funds aim to replicate the performance of a specific benchmark
index, such as the Nifty 50 or the Sensex. These funds involve minimal portfolio turnover,
with investments being held for longer periods and adjusted only to match the changes in
the index. Passive funds are characterized by lower expense ratios, making them a costeffective option for investors. Despite their lower costs, passive funds are not without risks,
as they are subject to market fluctuations and cannot outperform the benchmark.
Example
Let’s take one example by comparing two funds:
| Particulars | Fund A | Fund B |
| Style | Active | Passive |
| Expense Ratio | 0.60% | 0.20% |
| Return (Post Expenses) | 14% | 12% |
| Amount Invested | 10,00,000 | 10,00,000 |
| Time Period | 10 | 10 |
| Value at the end | $37,07,221 | $31,05,848 |
| Excess of Active over Passive | $6,01,373 | |
If we see, the fund manager of Fund A has generated the higher return of 2% by managing the money actively using his expertise rather than just copying the index. His expertise has resulted to a higher return than what the benchmark and the fund mimicking the benchmark has delivered. This excess is called as alpha. And to generate the alpha, the fund manager has used his expertise, skills and devoted time. To compensate for this, he will be paid higher fees than the fund manager of Fund A. In this case, it was worth paying the higher fees to the fund manager since he has delivered the higher returns. But what if he fails to do so? That’s the risk with the active fund management. The risk that the fund manager would not be able to beat the benchmark. Then which one is suitable for you?
Choosing a right fund
The choice between active and passive funds ultimately depends on your risk appetite, investment horizon, and financial goals. The main risk involved in selecting the active fund over the passive fund is the risk of fund manager’s underperformance. The fund manager may not be able to outperform the benchmark and you may end up paying higher fees.
Those who are willing to take the higher risk in pursuit of higher return, choose the active funds. On the other hand, those who are satisfied with the approximate return of the benchmark with reduced expenses, end up choosing passive funds.
Deciding between active and passive mutual funds is a complex task that hinges on your individual investment goals and risk tolerance. Active funds, with their higher potential returns and associated risks, are suitable for investors willing to pay for professional management and who can handle market volatility. On the other hand, passive funds are ideal for those seeking a low-cost, long-term investment strategy that requires minimal active management. By carefully assessing your financial situation and investment objectives, you can make an informed choice that best suits your needs, ensuring a balanced and well-planned approach to wealth creation.
While passive funds have gained traction, active funds remain more prevalent in India. Investors often prefer active funds due to the variety of options and the potential for high returns, especially for long-term goals such as funding a child’s education or retirement. However, selecting the right active fund requires thorough research and analysis, as not all active funds consistently outperform their benchmarks.
