Difference between Active Funds & Passive Funds | ICICI Bank

Investing your hard-earned money is a significant decision and choosing the right investments should entail due diligence. Among the many popular choices today are actively managed Mutual Funds and passively managed Index Funds. While they share similarities, understanding their differences is important for more accurate investing. In this comprehensive guide, you can wade into the Active vs Passive Funds discussion and decide which one aligns better with your financial goals.

What Is a Mutual Fund?

In India, Mutual Funds are meticulously crafted investment instruments that pool money from multiple investors. When you invest in a Mutual Fund, you essentially acquire a share of ownership in the fund. This entitles you to a proportionate allocation of the income and capital gains generated by the fund.

A dedicated investment manager oversees the fund's assets, which are diversified across various asset classes like stocks, bonds and securities. These experts make crucial decisions regarding which assets to buy, sell and trade, all with the aim of optimising returns and managing risks efficiently within the Indian investment landscape.

What Is an Index Fund?

In India, an Index Fund is not a distinct investment vehicle but rather a type of passively managed Mutual Fund. Its purpose is to closely track the performance of specific market indices like the Nifty 50 or the Sensex. Index Funds in India operate by replicating the holdings and weightings of securities within the chosen index, with the aim of matching the benchmark index's performance as closely as possible.

These funds may include all the holdings within the index or a representative sample of them. The primary objective of Index Funds is to mirror the returns and movements of the underlying index. Index Funds have gained popularity among Indian investors, especially those with a long-term, passive investment strategy, due to their lower costs and consistent tracking of market benchmarks.

Active vs. Passive Management

Mutual Funds can be categorised as actively managed or passively managed:

What are Active Mutual Funds?

In actively managed Mutual Funds, an investment professional or a team of portfolio managers handpick investments with the goal of outperforming a stock market benchmark. These funds often come with higher fees due to the active management involved.

What are Passive Mutual Funds?

Passively managed Mutual Funds, on the other hand, aim to mimic the performance of market indices. They do this through automated or mostly hands-off systems, which results in lower management fees. For many Mutual Fund investors, particularly those saving for retirement or other long-term goals, passively managed funds are an attractive choice due to their broad diversification.

Key Differences to Consider

While both Index Funds and Mutual Funds offer portfolio diversification, several key distinctions should influence your decision:

1. Objectives:

Mutual Funds: These funds are actively managed and their primary objective is to outperform market benchmarks. Investment professionals actively select and manage the fund's holdings.

Index Funds: They follow a passive investment approach, aiming to match their chosen index's performance as closely as possible. No active management decisions are made to select individual securities.

2. Costs:

Mutual Funds: Actively managed funds typically come with higher expenses, reflected in their total expense ratios (TERs), which often range from 1% to 2% in India.

Index Funds: These funds are known for their cost-effectiveness. They have lower TERs, typically falling within the range of 0.20% to 0.50% in India. The passive management strategy keeps costs down.

3. Flexibility:

Mutual Funds: Actively managed Mutual Funds are more flexible because their managers can respond to market changes by adjusting the fund's holdings.

Index Funds: These funds are less flexible as they aim to replicate specific index holdings and do not actively respond to market changes.

4. Risks:

Mutual Funds: Actively managed Mutual Funds can be riskier due to the portfolio manager's goal of outperforming the market. Poor decisions can negatively affect fund performance.

Index Funds: These funds are generally considered lower-risk investments. Their passive strategy aims to match market performance, reducing the risk of poor decision-making.

Pros and Cons: Active vs Passive Funds Investing

Active Funds

Pros:

• Active funds offer you the potential to handle the market with the help of expert decisions and research-based fund selection.

• You can adjust the strategies that are based on market movements and trends.

• These funds offer professional fund management for investors. It helps those who lack market knowledge.

Cons:

• A major drawback of these funds is that they come with higher costs because of active management and fund manager charges/fees.

• The returns mainly rely on the skills and timing of the fund manager.

Passive Funds

Pros:

• Passive funds, on the other han,d have a lower expense ratio. This is because it only aims to replicate an index, not go beyond it.

• It offers a transparent investment style, which makes it easy for beginners to understand.

• Such funds are quite suitable for long-term investors looking for low-cost and market-matching returns.

Cons:

• The funds cannot outperform the market as they only track the index.

• There is no flexibility to respond when it comes to market volatility or opportunities.

Considering before investing in active & passive funds

• Investment Goals: The first thing to consider is your goals. Analyse properly about your goals. For example, whether you are looking for higher returns (active) or stable, and market-linked growth (passive).

• Risk Appetite: Next is your risk tolerance. As we know, active funds carry more risk but higher return potential. On the other hand, passive funds are ideal for conservative investors searching for steady growth.

• Cost Factor: Active funds have higher expense ratios due to management fees. Passive funds are low-cost, ideal for long-term investing.

• Market Knowledge: Active funds require trust in a manager’s skill and passive funds are simple so they don’t need deep market understanding. Choose wisely as per your preference and also note that the fund manager carries a certain fee.

• Time Horizon: For short-term flexibility, active funds work better. In long-term, passive funds offer low-cost compounding benefits. For the best decision, you must choose as per your timeline.

Active Vs Passive funds: What to choose?

The final choice between active and passive funds relies on your financial goals and comfort level. If you are someone looking for higher returns and trust expert fund managers to pick the best stocks, then active funds can be the right choice. Remember these may come with higher fees.

On the contrary, if you are looking for a low-cost, and easy option that grows steadily with the market, passive funds are a good choice. These are ideal for beginners and long-term investors. Think about your risk appetite, budget, and time before investing.

Which funds are better? Active or Passive?

Here is a detailed guide for active vs passive Mutual Funds to help you make a smart choice.