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When the best investment advisor plans to construct an investment portfolio for its clients, a lot of thought goes into deciding about its contents. How much should be invested in active vs how much should be put in passive mutual funds? And this is another one of those never-ending debates, in the mutual fund sector.
Besides, for the past couple of years, passive funds have been doing relatively better than active large-cap funds. And thereby become famous.
Even though passive funds are not much popular in India. We, investors in India, have traditionally preferred schemes that are actively managed by fund managers or active funds. Probably, because of the perception that they will beat the returns of the underlying benchmarks and generate the so-called alpha. And that has been true so far, as well.
However, now, quite a lot of passive funds have beaten actively managed funds.
Besides, in most developed countries, passive funds are the preferred method to invest in the stock market.
Because this discussion has the potential to affect the returns you earn, therefore, it is quite important. So read on.
The first thing to understand would be what are Active vs Passive Funds.
What are Active Funds
Active investing means investing in funds whose fund managers, co-managers, or a team of managers, take an active interest in selecting investments. These decisions are based on an independent assessment of the worth of each stock. And, trying to choose the one with the best potential.
Such Fund Managers pay close attention to market trends, shifts in the economy, changes in the political scenario, and factors that may affect specific companies. This data is used to time the purchase, sale or the duration of investments. And to take advantage of the conditions.
All these processes have been claimed to boost the potential for returns. Much better than those achieved by simply following the stocks or other securities listed on a particular index.
The objective of the fund manager in an actively managed fund is to beat the market. Or outperform the relevant benchmark. Therefore, he or she must take on additional market risk to obtain the returns necessary to achieve this end.
The fund manager puts in a lot of effort and calculations to pick quality stocks in the hopes of outperforming the index. Some stocks do perform better than others. Because of the fund manager has managed to pick stocks that deliver supernormal returns, then it is successful.
At times, the fund manager may prefer to invest in safe-haven options such as cash and gold. Any which way is suitable to achieve the goal of outperforming returns that the market gives.
But all this selection requires the right mixture of in-depth research, market forecasting, and the experience, expertise, and intuition.
Of course, active funds come with a set of costs. The fees are higher. And there is the possibility of underperformance than the market as the selection may go wrong.
Benefits of Active Funds
- Opportunity to outperform the market
- It can be tailored to specific goals
- Risk management
- Downside protection
- Proactive
Drawbacks
- Higher cost
- Less tax efficient
- Requires more research from the investor’s side
What are Passive or Index Funds
If you’re a passive investor, you wouldn’t evaluate the quality of each particular part of your portfolio. These Mutual Funds are also known as index mutual funds. They track the returns of a particular market index or benchmark as closely as possible.
The goal of passive mutual funds is to match the performance of the related market indexes. Instead of trying to outperform it.
Fund managers of Passive mutual funds simply acquire all the stocks in a given market index. In the same proportion as they are held in that index. That is, the mutual fund portfolio will copy the constituents of the index in their exact proportion in the index. Managers select stocks and other securities listed on an index and apply the same weighting.
Index mutual funds offer a relatively safe approach to investing in broad segments of the market.
A passive fund does not have a management team, actively making decisions to invest or divest. Index funds are branded as passively managed because their fund manager copies the index. And not trade securities based on his/her understanding of the risk and reward characteristics of various securities. Because the investment strategy is not proactive, the fees and expenses assessed on passive funds are far lower than active management strategies.
Active vs Passive Funds
| Active Mutual Funds | Passive Mutual Funds |
|---|---|
| Potential of getting Higher Returns | You don’t believe it’s possible to beat the market |
| High Cost | Lowest Possible Cost |
| Investing for specific investment objectives | Investing without goals |
| You may need to withdraw early when the market may be down | The investment horizon is long-term |
| The sector has no particular index or where good oversight is essential | Taxes are a concern |
Active vs Passive Funds: Which is better
In the end, it depends solely on the investor. It all comes down to personal preference and your investment goals.
If you can stay invested for a long time. And you are sure that you won’t need your funds for a while. In that case, you may consider investing in passive Mutual Funds.
But if the timing is crucial and you prefer a more aggressive approach, active funds might be worth exploring.
If you are a newbie. Just starting to invest, letting an experienced team take care of your money makes better sense. Either that or, at least, taking the help of an professional, is advised, under the circumstances.
As the manager tries to beat the market. Each time they succeed, it would translate into better than average returns. Active funds depend on the intuition of the fund manager to pick and choose the right security, at the right price and the right time.
Additionally, having an active fund manager on board may give investors access to products that the average person cannot obtain.
Though the active funds have benchmark indices, too, they are not bound to copy them. They consider it as a benchmark. But are not bound to buy the same proportion of stocks and keep the same ratio as in the Index. They don’t believe in following the benchmark. And some differ greatly from where their benchmark indices invest.
The fund manager and team will do research and evaluate the potential of future growth of the stock. Accordingly, keep or sell out of the fund’s portfolio. Because they have to beat the index to show their worth to the investors. They study all relevant information thoroughly. Before taking the call.
Beating the Index does not always mean just capturing the upside of the market. It also means protection when the market is on the downside.
In developed markets, like Europe and the US, passive funds are popular. In emerging markets, including India, active funds are more common vs passive funds. This is because of the lack of information and imperfect markets. However, as the technology is catching up in India. And the market is maturing, the strategies and opportunities to outperform the market become scarce. This would gradually bring on the era of passive investing.
In Passive Funds, there is no risk of error in judgment in terms of stock selection. They are not traded as often. So you have to pay lower expense ratios and are more tax-efficient than actively managed funds.
Though passive investing, definitely has its benefits. Still, in many cases, active management may help investors improve their risk-adjusted returns. The returns from actively managed funds are much higher during periods of market stress. When such outperformance becomes critical for certain investors.
Can Passive Funds in India be able to replace Active Funds Completely?
No. The reason is that in Passive Funds, the changes in the portfolio will be made only after the change has been updated in the Index. This, of course, does not happen instantly. Meanwhile, the returns may get affected. This phenomenon is also known as Tracking Error. It tells how much the fund manager of the passive fund has failed in Tracking the Index.
Conclusion
Not every investor has the time to study the market. Besides, if the fund manager(s), who are chosen on the basis of their qualifications and expertise can make mistakes (the main reason for going against Active Funds). How can a general investor be sure about his/her selection? They with their team and complete understanding of the many analytical tools to help them make a decision. With their understanding or knowledge of the market. Still, the future cannot be predicted. The same holds true for an individual investor, as well.
Therefore, for some, engaging with an active fund manager to oversee their investments might be a good option.
Or, if you’ve been investing for a while. Are a veteran. You might have gained insights into the market. Then it may be a good idea to opt for Passive Investing. But not before you have reviewed your portfolio to ensure it still aligns with your goals and current circumstances.
Whichever way you choose, having a clear strategy in place is the first step, essential for the success of your investment journey.
With so many conditions, ratios and options to analyze. Finalizing the fund in which you put your money is an intimidating task.
Therefore, it is advisable that you take the help of professionals. Therefore, it is advisable that you let WealthBucket assist you. Let us help you out in short-listing and personalizing your investment.
Our services relate to but are not limited to, Equity Mutual Fund, Debt mutual fund, Large Cap mutual fund or Multi-Cap mutual fund.
Do call us at +91 8750005655. Or you can mail at contact@wealthbucket.in.
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