Passive vs Active Mutual Funds: Which is better for investment?

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Passive Mutual funds are in the news these days. Even stock trading platforms like Zerodha and Angel Broking are reportedly planning to enter the asset management business by focussing on passive investment products. From the investor’s point of view, it is important to understand the difference between active and passive mutual funds and what may be better for them.

According to Harshad Chetanwala, Co-Founder, MyWealthGrowth.com, passive funds have outperformed actively managed funds in the last couple of years. Because of this, these funds continue to see the increasing interest of investors.

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“Passive funds offer investment based on market capitalization where these funds mimic the indices created by NSE or BSE and do not have any active role of the fund manager. Whereas, active funds invest in companies based on their research and views of the research team along with the fund manager. These funds can invest in companies that have the potential to grow at a faster rate compared to those with just high market capitalization,” Chetanwala told FE Online.

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“In case of active funds, there is a possibility of higher returns compared to the benchmark index, but there is also a possibility of inferior returns, in case of problems in the stock selection by the fund manager. While with the passive funds, the investors are sure of generating market-linked returns. For example, if the NIFTY 50 index generates a return of 12% pa for the next 5 years, then the index fund will also generate similar returns,” Anurag Garg, Founder and CEO, Nivesh.com told FE Online.

Which is better for investment?

There are many companies where the scope of improving efficiency and performing well across different sectors continue to exist. You can invest in such businesses through active funds.

However, Chetanwala said, “A blend of active and passive funds can work well over the long term. Investors who are beginning with their mutual fund investment can have higher allocation in passive funds whereas investors with moderate to high-risk appetite can look at 15-20% allocation in these funds and the rest can be in active funds.”

“Investors can consider NIFTY, SENSEX or NIFTY Next 50 for investing in passive funds. In the active fund space, you can look at Large & Mid Cap and Flexi Cap funds,” he added.

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Gupta said that Indian markets are inefficient which gives opportunities to fund managers to identify investment opportunities and generate superior returns, resulting in a higher preference for actively managed funds versus passive funds.

“However, in the developed markets like the US, markets are highly efficient and as a result, preference for passive funds is increasing,” he added.

Gupta said that a problem in Indian markets is that there are very few options for passive funds. Most of the funds are linked to the two prominent indices – NIFTY 50 and Sensex. “Lot of ground needs to be covered before passive funds gain more popularity in Indian markets,” he said. This probably also explains why firms like Zerodha are planning to enter the passive funds business.

According to Chetanwala also, as the stock market and investors become more matured we will see more preference towards passively managed funds.

Top-performing Active and Passive Funds

Source: Harshad Chetanwala, Co-Founder MyWealthGrowth.com

Active vs Passive Mutual Funds

In active mutual funds, fund managers actively manage the funds. These managers have to take proactive decisions to buy or sell a particular stock depending on market conditions and fundamental attributes of the stock. The aim of the fund manager of an active MF is to generate returns higher than the returns of the benchmark index.

For example, the fund manager of a large-cap active mutual fund (which is tracking NIFTY50 index as benchmark index) would try to generate returns higher than returns generated by the NIFTY50 index.

The Fund manager is supported by analysts and the research team to carry out research and track the performance of the companies in which investment is being made. Since the people involved in the process are well paid, it adds to the cost of the fund management leading to comparatively higher expense ratios of actively managed funds. Therefore the fund manager has to generate higher returns to justify the higher expense ratio of the fund, said Gupta.

However, in passive funds, fund managers do not trade in stocks actively, and such funds are known as index funds. The investment is done in the stocks comprising the index and in the same proportion as that of the index. The objective is to generate a return similar to the index.

The expenses of managing passive funds are generally lower than the active funds because a specialized team is not required to track the market. Such funds generate market-linked returns.

(Disclaimer: Investment in mutual funds is subject to market risks. The views and suggestions offered above are those of respective experts/commentators. Please consult your financial advisor before making any investment decision.)

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