Active vs Passive Funds: Which is the Best Investment Strategy in India?
Explore the key differences between active and passive funds in India.
Active vs Passive Funds: Which is the Best Investment Strategy in India?
Investing in mutual funds is a popular way for Indian investors to grow their wealth. One of the key decisions that investors face is whether to opt for active or passive funds. Both types of funds have their advantages and disadvantages, and understanding the differences between them can help you make more informed investment choices.
Let’s explore the main differences between active and passive funds in India and how they fit into an investor's strategy.
What Are Active Funds?
Active funds are managed by professional fund managers who make investment decisions based on research, market analysis, and stock selection. The goal of these funds is to outperform a benchmark index by selecting individual stocks that are expected to provide higher returns.
In active funds, fund managers try to time the market and capitalize on opportunities by buying and selling assets. This approach gives investors the potential for higher returns, but it also comes with increased risk. Active fund managers may use techniques like fundamental analysis, technical analysis, or market timing to make decisions.
Returns:
Active funds aim to outperform the benchmark index, but performance can vary. Some funds succeed and generate returns that exceed the benchmark, while others may fall short. Therefore, the returns are not guaranteed and can fluctuate.
Costs:
Active funds typically have higher management fees compared to passive funds. These fees can range between 1.5% to 2.0% of Assets Under Management (AUM), primarily due to the research, analysis, and transaction costs associated with active management. These higher fees can reduce the net returns for investors.
Risk:
Active funds have a higher risk profile since they rely on the skill of the fund manager. The potential for both higher returns and losses is more pronounced. In addition, these funds tend to be more volatile since they are influenced by the fund manager’s decisions and market conditions.
What Are Passive Funds?
Passive funds, on the other hand, aim to replicate the performance of a specific market index like the Nifty 50, BSE Sensex, or other sectoral indices. Instead of actively selecting stocks, these funds invest in the same stocks that make up the index, in the same proportion. The main goal of passive funds is to mirror the returns of the benchmark, minus fees.
Returns:
Passive funds closely track the benchmark’s performance, so their returns are predictable. While they may not exceed the market returns, they typically perform in line with the index, offering stable and consistent returns over time. After accounting for fees, passive funds often outperform active funds in the long run, especially when compared to funds with higher management fees.
Costs:
One of the main advantages of passive funds is their low cost. Since these funds don't require active management, the expense ratio is typically lower-around 0.50% of AUM. This low cost makes passive investing an attractive option for investors looking to maximize their returns by minimizing fees.
Risk:
Passive funds tend to have lower volatility than active funds. Since they are tied to a broad market index, they provide broad diversification, which helps reduce the risk of significant losses. However, they won't outperform the market either. The risk is limited to the overall market performance, and these funds are less impacted by individual stock movements.
Key Differences Between Active and Passive Funds in India
Particulars | Active Funds | Passive Funds |
Returns | Target higher returns than the benchmark through stock selection and market timing. Performance can vary. | Track the performance of a benchmark index with returns closely mirroring the market’s performance, minus fees. |
Costs | Higher fees (1.5%-2.0%) due to active management, research, and transactions. | Lower fees (0.50%) due to minimal management. |
Risk | Higher risk with the potential for both greater returns and greater losses, dependent on manager skill. | Lower volatility as they track broad market indices, with steady long-term performance. |
Management Style | Actively managed with ongoing stock selection and market timing. | Passively managed to replicate index performance. |
Choosing Between Active and Passive Funds
When deciding between active and passive funds, investors need to consider their financial goals, risk tolerance, and time horizon.
Time Horizon:
For long-term investors, passive funds may be a more reliable choice. Over extended periods, passive funds tend to offer consistent returns that closely align with the market’s growth. They are also less likely to underperform significantly when compared to active funds over the long term.
Market Conditions:
In volatile or bear markets, some investors may prefer active funds. Experienced fund managers can use strategic stock selection to potentially mitigate losses during market downturns. However, passive funds offer a more straightforward and less time-consuming investment strategy during such periods.
Personal Preference:
Some investors enjoy the hands-on approach of actively managed funds, while others prefer the simplicity and cost-effectiveness of passive funds. If you’re someone who enjoys tracking individual stocks and market movements, active funds might be more appealing. Conversely, if you prefer a set-it-and-forget-it approach, passive funds may be a better fit.
The Future of Passive Funds in India
The popularity of passive investing in India is on the rise. The introduction of new indices, such as the Nifty Tourism Index and the Nifty Capital Markets Index, is creating opportunities for investors to diversify into specific sectors with high growth potential. These new indices cater to changing investor preferences and allow for more targeted strategies.
The National Stock Exchange (NSE) has also launched a dedicated website for passive funds, which provides retail investors with comprehensive insights into the industry. This platform, accessible at www.indiapassivefunds.com, aims to empower investors by offering easier access to information and supporting informed decision-making.
As of September 2024, the total Assets Under Management (AUM) in passive funds stands at Rs. 11.2 lakh crores, with equity funds making up the majority of this amount. The growth in passive investing reflects its increasing adoption by both retail and institutional investors.
Top Passive Funds in India
Here are some of the top-performing passive funds in India based on 3-year returns:
1. CPSE ETF - 44.95% (3-year return), AUM: ₹44,278.8 crore
2. Bharat 22 ETF - 34.58% (3-year return), AUM: ₹20,613.4 crore
3. Nippon India ETF Nifty PSU Bank Bees - 33.7% (3-year return), AUM: ₹2,475.19 crore
4. Kotak Nifty PSU Bank ETF - 33.71% (3-year return), AUM: ₹1,349.39 crore
These funds have consistently provided strong returns, highlighting the potential of passive investing in India.
Conclusion: Active vs. Passive Funds
Both active and passive funds offer unique advantages depending on your investment style and goals. Active funds provide the potential for higher returns but come with higher costs and greater risks. Passive funds offer a low-cost, stable investment strategy that closely tracks the market.
For Indian investors, understanding the differences between the two can help you make a more informed decision based on your financial objectives and risk tolerance. Whether you choose active or passive funds, it's essential to regularly review your portfolio and make adjustments as needed to align with your long-term financial plans.
