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Active funds vs passive funds: Which one should you choose?

Mutual funds have become a hot topic of discussion among everyone. The general curiosity among people about mutual funds have increased, especially after the ‘ Mutual Fund Sahi Hai’ campaign that went live a few years ago. Mutual funds come in different shapes and sizes, and they can be classified into various segments. Mutual funds can be broadly classified into active and passive funds.

Active Funds

Actively managed funds are the most common category of mutual fund. In an actively managed fund, the fund manager is responsible for stock picking based on the scheme’s objectives. His objective is to beat the fund’s benchmark. This leads us to the concept of the benchmark. To gauge the performance of the fund, every fund tracks a specific benchmark. The benchmark is typically the broad market indices such as Nifty 50 TRI or BSE 200 TRI. The benchmark of the fund depends on the category of the fund. E.g., if the fund is a small cap equity fund, then its benchmark is most likely to be Nifty 500 TRI than Nifty 50 TRI.

Passive Funds

Passive Funds mirror the benchmark. That means that the fund will invest in stocks as per the index. The goal of the passive fund is not to beat the index but deliver the same returns as the index.  The extent to which the fund does not track the index is called the Tracking Error. Tracking error is an essential determining factor in passive investment. Tracking error is the percentage of deviation from the index. E.g., if the index has gained 5% in a month and the returns given by the index fund is 4.5%, then the tracking error of the fund is 0.5%. In the second scenario, if the index fund has given a return of 5.5%, then the tracking error of the fund is still 0.5%.

There are two main reasons behind tracking error in index funds.

The constituents and the proportion of the different companies in the index keep on changing. If there is any such significant change such as addition and removal of stocks in the index, the fund will show a higher tracking error till the fund manager can align the portfolio as per the new changes. Large scale redemption pressures from investors is another reason behind the tracking error. If the redemption requests are more than inflows, the fund manager has to sell shares to honour the redemption requests. It will lead to a higher tracking error as the fund won’t be in sync with the index.

Difference between active and passive fund

Objective: The objective or the goal of the active funds is to beat the benchmark. The higher the outperformance, the better is the fund. On the other hand, passive funds seek to give index returns. The lower the deviation from the underlying index, the better is the fund.

Returns:Active funds have the potential to deliver high returns as the experienced fund managers manage these funds. During a phase of falling markets, active funds tend to fall lower than the broader market.

Fund manager’s role:In active funds, fund managers play an active role in stock picking. However, there is no role of the fund manager in passive funds. The fund manager has to increase or decrease allocation to a specific stock as per as the underlying index. 

Expenses:Active funds charge a higher expense ratio than passive as the fund managers play an active role in stock selection, which is not the case in passive funds.

Which one is best for you?

Passive investment is still in nascent stages in India. Many top fund managers have beaten the benchmark by a higher margin. As the Indian market is still growing, fund managers have ample opportunity to identify growth stocks with their strong research team and beat the benchmark. Thus, investors tend to earn higher returns by investing in active funds.

Volatility is part and parcel of the Indian market as geo-economic factors like trade wars and internal factors like elections and politics play a significant role in the Indian market. Hence, by taking the active route, you can be assured that the fund will give better returns or fall less than the overall market.

One of the drawbacks of the active funds that has been a constant topic of discussion is the higher costs. However, the market regulator has addressed this issue by cutting the expense ratio of equity funds to 2.25% from 2.5% and debt funds to 2% of their daily net assets.

To summarise, in the current scenario, investors may be better off by investing in active funds as it has the potential to earn higher returns.