Active vs. Passive Funds: Key Differences and Which is Better

Active and passive mutual funds differ in how they are managed. Active mutual funds are overseen by professional managers who make strategic investment decisions to try and outperform a specific market index, but this approach typically involves higher fees and increased risk. In contrast, passive mutual funds aim to mirror the performance of an index by holding the same securities in similar proportions, offering lower fees and more stable returns, but without the possibility of beating the market. Investors choose between the two based on factors like cost, risk appetite, and their investment objectives.

Let’s understand in depth what these funds are all about:

Mutual fund portfolios can be either actively or passively managed. Portfolio management refers to how the underlying assets (such as equity, debt, or gold) are bought and sold by the fund manager. In an actively managed fund, the manager plays a more hands-on role, making decisions about which stocks and bonds to include in the portfolio and when to buy or sell them. Conversely, in passively managed funds, the fund manager has no control over the movement of the underlying assets, as the portfolio is designed to track a specific index.

Actively managed portfolio

Actively managed portfolios include equity mutual funds, debt mutual funds, hybrid funds, and fund-of-funds. For example, in an equity fund, a dedicated fund manager actively selects which stocks to include or exclude based on market performance, economic conditions, and individual stock performance.

The manager also decides whether to adjust the concentration of existing stocks or modify the amount invested in them. In essence, the performance of an actively managed equity fund heavily relies on the fund manager's decisions. This approach applies similarly across all types of actively managed funds.

Key features:

• Manager’s role- Fund managers or a team actively make investment decisions based on in-depth research, market trends, and analysis.
• Objective- The primary aim is to outperform the market or exceed the performance of a specific index, such as the S&P 500.
• Fees- Typically associated with higher fees (expense ratios) due to the costs of active management, research, and frequent trading.
• Risk & return- Offers the potential for higher returns but also comes with increased risk due to dependence on the manager’s expertise and market forecasts.

Pros

• Potential for higher returns if the fund manager demonstrates skill.
• Ability to adjust the portfolio in response to market changes and opportunities.
• Focus on specific investment themes, sectors, or goals.

Cons

• Higher fees and expenses can diminish net returns.
• Increased risk of underperforming relative to the index.
• Performance largely depends on the fund manager’s expertise.

Passively managed portfolio

Exchange-Traded Funds (ETFs) are a prime example of passive investing. ETFs track the performance of a specific index without altering its composition. The fund’s role is to mirror the index's movements, as changes to the index are managed by entities like SEBI, not by the fund managers. The returns of the ETF reflect the performance of the index, though there may be slight differences due to expenses, management fees, or dividends.

HDFC Sensex ETF holds stocks in the same proportions as the Sensex. The fund manager’s role is to ensure that the ETF reflects any adjustments made to the Sensex. Here, the manager's task is replicating the benchmark's performance rather than actively selecting or adjusting the investments.

Key features:

• Manager’s role- Fund managers have minimal involvement, with the fund investing in the same securities as the index it tracks.
• Objective- The aim is to replicate the performance of the index rather than outperform it.
• Fees- Generally lower fees and expense ratios due to reduced active management and trading.
• Risk & return- Lower risk compared to active funds, as the fund mirrors the broader market. Returns are designed to align closely with the index’s performance.

Pros:

• Lower fees, which can enhance long-term returns.
• Reliable performance that mirrors the index, reducing the risk of underperformance.
• Well-suited for long-term investors seeking broad market growth.

Cons:

• No opportunity to surpass market performance or capitalise on short-term fluctuations.
• Limited flexibility to adapt to sudden market changes or emerging trends.
• During market downturns, there’s no strategic manoeuvring to mitigate losses.

To summarise, here are the key differences between active and passive mutual funds:

Passive vs Active investing: which one should you choose?

Choosing between passive and active investing isn’t about determining which is inherently better; it’s more about understanding their distinct features and how they align with your investment goals.

Passive investing, exemplified by ETFs, involves tracking a specific index without altering its composition, offering a straightforward approach with minimal management decisions.

Active investing, on the other hand, involves fund managers making strategic decisions to potentially outperform the market, suitable for those who can afford higher fees with increased risk.

Ultimately, the decision hinges on your individual investor profile. If you prefer hands-on management, can manage the associated costs, and are aligned with the risks and goals of active investing, then active funds might be a good fit. However, if you favour a more stable approach where the fund closely tracks a benchmark with minimal managerial intervention, passive funds could be the better choice.