Active vs. Passive Mutual Funds

Active vs. Passive Mutual Funds: Which one you should buy?

The Indian mutual fund industry is at a pivotal juncture, with investors navigating a sea of options between active and passive funds. While some swear by the expertise of active fund managers, others prefer the simplicity and cost-effectiveness of passive investing.

But the main question lies with choosing the right fund for our portfolio and lot of time we chase the fancy things rather the rational ones. How often have you struggled with the choice between making a rational decision and getting swept up by the latest trend? A common mistake people make today is FOMO (Fear of Missing Out), which pushes us to act in a hurry without proper research or insights. Well, understanding these important factors in depth becomes paramount, especially in today’s world. Let dive deeper to understand better about this investment options & look into some data to make wiser choice going forward.

What is a Mutual Fund?

A mutual fund is like a common investment bucket where money from many people is pooled together. Everyone invests with the same goal of growing their wealth with the help of a professional money manager. These professionals invest the money in different assets like stocks, bonds or commodities to help it grow the investor’s money while reducing risk of losing capital.

Mutual funds are managed in two distinct ways: active and passive. Let’s explore each approach to understand them more clearly.

What Are Active and Passive Mutual Funds?

Active Mutual Funds

Active mutual funds are managed by professional fund managers who aim to outperform a specific market index or benchmark. They actively buy and sell securities, leveraging research, market trends, and analytics.

Passive Mutual Funds

Passive mutual funds, such as index funds and ETFs, aim to replicate the performance of a benchmark index (created by stock exchanges to represent the market or a segment of it). They do not involve active buying or selling, making them cost-effective and transparent.

Key Differences Between Active and Passive Funds

Cost Comparison: Active vs. Passive Funds

Active Funds: Expense ratios typically range between 0.50% to 2.70%. These fees compensate fund managers and cover research and administrative costs.

Passive Funds: Expense ratios are as low as 0.1% and 2.5%, making them more suitable for cost-conscious investors.

Performance of Active Funds in India (2023)

According to the SPIVA India Year-End 2023 report, active funds had a mixed year:

1. Large-Cap Funds

. 2023 Performance: 51.6% underperformed the S&P BSE 100, which gained 23.2%.

. Long-Term (10-Year): 62.1% underperformed.

2. Mid/Small-Cap Funds

. 2023 Performance: 73.6% underperformed the S&P BSE 400 Mid & SmallCap Index, which surged 44%.

. Long-Term (10-Year): 75% underperformed.

3. ELSS Funds

. 2023 Performance: Only 30% underperformed the S&P BSE 200 Index, which rose 24.5%.

. Long-Term (10-Year): 67.6% underperformed.

4. Government Bond Funds

. 2023 Performance: 81.5% underperformed the S&P BSE India Government Bond Index, which grew by 7.9%.

. Long-Term (10-Year): 90% underperformed.

Advantages of Active Mutual Funds

1. Potential for Outperformance: Skilled fund managers can identify opportunities that may outperform the market. He has access to team of well experienced analyst, portfolio managers & plethora of data.

2. Flexibility: Managers can adjust portfolios in response to market conditions & take active calls. These attributes of professional fund management can help the portfolio outperform the benchmark.

3. Personalization: Funds can invest in specific market caps, sectors or themes which offers significant opportunities for wealth creation.

Why Do Many Active Funds Underperform?

1. Market Efficiency

Indian equity markets, especially large-cap segments, have become more efficient, making it harder for fund managers to outperform benchmarks as the large cap space has fewer options to explore.

2. Unpredictable Performance

A lot of times, the fund manager is afraid of significantly underperforming the benchmark, which is why they tend to follow the benchmark portfolio allocation closely. While this approach may protect the fund manager from deviating too much from the benchmark, it also reduces the potential for alpha generation.

3. Higher Costs

Active funds incur higher cost than an index fund, which eat into returns, especially in a year where market returns are moderate. The cost mainly incurs due to higher portfolio churning and management fee with respect to index funds.

Advantages of Passive Mutual Funds

1. Lower Costs: It has less cost than an actively managed fund. The difference between the expense ratio with respect to active fund adds to the return of passive fund.

2. Simplicity: Passive funds are simple and they are built to replicate the specific benchmark.

3. Less churning: Index funds are periodically rebalanced and hence there less churning in the portfolio. So this reduces the cost of trading assets on a frequent basis unlike active funds.

When to Choose Active Funds

1. You Trust a Star Manager: Fund managers with a proven track record can make a difference.

2. Seeking Specialized Strategies: If you want exposure to niche sectors or themes.

3. Market Inefficiencies: Smaller, less efficient markets may offer opportunities for outperformance.

When to Choose Passive Funds

1. Cost Matters: If you want to minimize fees and maximize returns.

2. Long-Term Horizon: Index funds are ideal for buy-and-hold investors.

3. Limited Time: Passive funds require less monitoring and research.

What Should Investors Do?

1. Assess Your Goals

Understand your financial objectives and align them with the right asset classes like equities, bonds or commodities to achieve your financial goals on time.

2. Evaluate Performance

Periodically review how investments perform against market trends and identify factors influencing their growth. If your portfolio deviates from your financial objectives, regularly rebalance it to realign your asset allocation with your goals.

3. Diversify

Spread your investments across multiple asset classes to reduce risk and balance returns.

4. Keep Costs in Check

Monitor any fees or charges associated with your investments to ensure they don’t erode your returns. Lot of time these types of funds make changes in their fees, so it becomes important to track them regularly.

The Future of Active and Passive Investing in India

The Indian market is evolving rapidly, with growing investor awareness and access to global investment products. As passive funds gain popularity, fund houses are introducing innovative ETFs and index funds. However, active funds still have a place, especially in less efficient market segments like small caps, midcaps or emerging themes like ESG (Environmental, Social, and Governance) etc.

Conclusion

Active and passive mutual funds each have their merits and drawbacks. While active funds can deliver outperformance in specific scenarios, their higher costs and historical underperformance make them less appealing in efficient markets. Passive funds, on the other hand, are cost-effective, less sophisticated, and replicate the index. It is ideal for the people who wants simple investment avenues.

Investors must align their choices with their financial goals, risk appetite, and investment horizon. The key lies in understanding the market and making informed decisions — because, at the end of the day, your money deserves the best.