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Active vs Passive basics
  • Stories
  • Understanding Active vs. Passive Funds

Find the Right Fit: Understanding Active vs. Passive Funds

Introduction

Mutual funds typically take 2 different routes when it comes to fund management. Some mutual funds monitor the market throughout trading hours daily and actively make buy and sell decisions based on their own conviction, and fund manager thought and research processes. On the other hand, other funds do not decide the movement of the underlying assets in the fund, and instead track the performance of an industry benchmark, and modify the portfolio from time to time to accurately reflect the benchmark.  As an investor, understanding the differences between these two approaches is crucial for crafting a well-diversified portfolio to achieve investment objectives.

What are Actively Managed Funds?

Actively managed funds are those in which fund managers regularly select, manage, and rejig the underlying securities in the fund’s portfolio. The managers make decisions based on extensive research and analysis about which securities to buy, sell, or hold.

Through strategic asset allocation and security selection, the primary objective of actively managed funds is to outperform their respective benchmark indices, like Nifty, Sensex or sectoral index. Fund managers continuously monitor the markets, assess economic conditions, and leverage their knowledge to identify investment opportunities that could generate higher returns.

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What are Passively Managed Funds?

Passively managed funds, such as index or exchange-traded funds (ETFs), follow a different investment approach. Instead of actively selecting securities, these funds aim to replicate the performance of a specific market index, such as the Nifty 50 or the S&P BSE Sensex.
Fund managers of passively managed funds have a minimal role in security selection, as the fund’s holdings mirror the composition of the underlying index. The primary objective is to track the index’s performance as closely as possible rather than attempting to outperform it.

The Debate: Active vs. Passive Funds

Here are some key points to consider in the Active vs. passive Funds

Feature
Active Investing
Passive Investing
Strategy Actively managed by a fund manager Tracks a market index
Goal Outperform the market Match the market return
Expense ratio Typically higher Typically lower
Returns Potentially higher returns, but also potentially higher losses Market returns
Management Requires significant research and expertise to select funds Less management required

Things to Keep in Mind While Choosing

When deciding between active and passive funds, you must consider your investment goals, risk tolerance, investment horizon, and overall investment strategy. Here are some factors to consider:

  • Investment Goals: Actively managed funds for potential market outperformance, passively managed funds for market-matching returns and lower costs.
  • Risk Tolerance: Active funds carry higher risks than  passive funds, as stock selection can adversely impact portfolio returns
  • Diversification: Both options offer diversification
  • Cost Considerations: Active funds have higher expense ratios than passive funds, as the fund manager is actively involved in all decisions regarding the portfolio.

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Conclusion

While the debate between active and passive investing strategies continues, many investors opt for a balanced approach by incorporating both actively and passively managed funds into their portfolios. This diversified approach can help give twin benefits—potentially higher returns of active funds and the cost-effectiveness and broad diversification of passive funds.