Difference between Passive & Active Funds – Overview, Risks & Examples
Mutual fund houses offer schemes that follow two investing styles – active and passive. In an active scheme, the fund manager decides how to invest the unitholders’ money. In a passive scheme, the scheme money is invested in an index. This article explains the difference between passive & active funds.
What are active mutual funds?
As the name suggests, an active fund is managed actively by the scheme fund manager. Depending on the objectives of the scheme, the fund manager invests the scheme money in the constituents of a benchmark index. The fund manager's objective is to outperform the benchmark index and generate alpha for the investors.
The fund manager decides which index constituents to invest in, the number of shares to buy, when, and at what price to buy. A research team backs the fund manager's decisions. Similarly, at the time of sale, the fund manager decides which index constituents to sell, the number of shares to sell, when, and at what price to sell. In short, in an active fund, the fund manager takes all the buy and sell decisions at their discretion.
As the buy and sell decisions of an active fund are done by a fund manager backed by a research team, the cost of managing an active fund is high. Hence, the expense ratio of an active fund is high.
What are passive mutual funds?
A passive fund works totally in contrast to an active fund. A passive fund invests all the scheme money in the constituents of an underlying index. The money is invested in each index constituent in proportion to their weightage in the index. The scheme’s objective is to mirror or track the underlying index and deliver index returns to investors. Passive funds are also known as index funds.
The fund manager cannot decide which index constituents to buy or sell. Similarly, the fund manager has no say in the number of shares to buy, when, and at what price to buy. Whenever the index reconstitution happens, the fund manager has to buy the shares of the new index entrant/s and sell the shares of the excluded index constituent/s.
As a passive fund follows a buy-and-hold strategy, the cost of managing a passive fund is lower than an active fund. Hence, the expense ratio of a passive fund is lower than an active fund.
Differences between active and passive funds
Some of the differences between an active fund and a passive fund include the following:
|Active fund||Passive fund|
|It follows an active management strategy with the fund manager taking buy and sell decisions.||It follows the buy and hold passive management strategy, with the fund manager having no say in buy and sell decisions|
|Its objective is to outperform the benchmark index and generate alpha for investors.||Its objective is to replicate the underlying index and mirror its returns.|
|Due to the active management style backed by a research team and regular buy and sell decisions, the cost of managing an active fund is high. It reflects in the form of a high expense ratio.||Due to the passive management style, there is no requirement for a research team. Also, there are no regular buy and sell transactions due to the buy and hold strategy. Hence, the cost of managing a passive fund is low. It reflects in the form of a low expense ratio.|
|The returns of an active fund may be higher, at par, or lower than the benchmark index.||The returns of a passive fund are usually lower than the underlying index due to expense ratio and tracking error.|
|Active funds are subject to market risk and fund manager bias as the fund manager takes the buy and sell decisions.||Passive funds are only subject to market risk as the fund manager has no say in buying and selling decisions.|
Advantages and disadvantages of active mutual funds
The biggest advantage of an active mutual fund is that it has the potential to beat the benchmark index. If the fund manager's decisions work out well, the fund can generate alpha for the investors. However, this advantage becomes a disadvantage, if the fund manager's decisions go wrong. In that scenario, the fund can underperform the benchmark index and give lower returns. The fund's active management comes at a higher cost, resulting in a higher expense ratio. The high expense ratio hurts investors even more if the fund is underperforming the benchmark index.
Advantages and disadvantages of passive mutual funds
Passive funds are free from fund manager bias, which is advantageous for investors who prefer to invest in all the index constituents as per their weightage. Another advantage of passive funds is the low cost. It results in a lower expense ratio.
The biggest disadvantage of passive mutual funds is that they cannot outperform the underlying index. They can at best give index returns, and investors have to be content with that. If the passive fund has a high tracking error, that can be another disadvantage as that also reduces the returns for investors.
Special considerations for investing in active and passive funds
Before choosing a mutual fund for investment, you need to consider whether you want the fund manager to take all the buy and sell decisions on your behalf? Or do you want to invest in all the constituents of an index as per the weightage and are content with index returns? If you prefer the first option, you should invest in an active fund. If you want to remove fund manager bias, you should invest in a passive fund.
Over a period of time, as markets have become efficient, fund managers are finding it increasingly difficult to outperform the benchmark index. In the last couple of years, many large-cap funds specifically have underperformed the benchmark index. So, for large-cap funds, you may consider choosing index funds.
In the mid and small-cap space, most active fund managers have managed to beat the benchmark index and generated alpha for investors. So, you may consider choosing active funds for mid and small-cap funds.
Examples of active and passive funds
Some of the examples of active and passive funds in the large-cap space include:
Large-cap active funds
- Axis Bluechip Fund
- Mirae Asset Large Cap Fund
- ICICI Prudential Bluechip Fund
- IDFC Large Cap Fund
- SBI Blue Chip Fund
Large-cap passive funds (Nifty 50 Index funds)
- IDFC Nifty Fund
- UTI Nifty Index Fund
- HDFC Index Fund – Nifty 50 Plan
- ICICI Prudential Nifty Index Fund
- SBI Nifty Index Fund