Actively Managed Funds Vs. Passively Managed Funds
When it comes to mutual fund investing, investors can choose between actively managed funds and passively managed funds. While both aim to provide market-linked returns to the investors, these funds tend to differ on many parameters.
Here are the broad differences between active and passive funds:
An actively managed fund will follow active investment strategies, wherein professional fund managers decide on the kind of securities where they find deem fit for having in the portfolio. Further, fund managers may also position size in a stock based on his/her conviction in the stock, generally backed by in depth research on the stock by the analyst team.
In contrast, passively managed funds adopt a passive investment strategy. It means that the fund will track an underlying index, such as S&P BSE Sensex (representing top 30 companies in terms of market capitalisation), Nifty 50 (representing top 50 companies in terms of market capitalisation) etc. A fund manager dedicated to manage the fund has a responsibility to mimic/track the underlying index as closely as possible in order to reduce the potential tracking error.
Discretion on Stock Selection
Active funds allow the fund managers to choose different stocks and decide on their weights as per their performance outlook.
In contrast, the fund managers for passive funds cannot exercise any discretion to go beyond the securities in the underlying index or change the weightage of such securities in the portfolio compared to the weightage in the underlying index.
The fund manager of an active fund endeavour to generate returns for the investors which is over and above the benchmark index in the long run. As such, the fund managers will aim to generate alpha for their investors.
In contrast, the returns of the passive fund will be almost equal to the returns generated by the underlying index, subject to tracking error and fund expenses. By their structural design, passive funds cannot be expected to generate significant alpha for their investors.
Total Expense Ratio (TER)
Considering the active fund management strategy adopted by actively managed funds, such funds will tend to have higher fund management charges and higher expense ratios relative to the passively managed funds.
As per the guidelines on TER set by the regulator, actively managed fund are allowed to charge by upto 2.25%, however as the asset under management grows TER of actively manager funds reduces as per the defined slabs. On the other hand, the TER of passively managed funds are capped at 1%, which makes passive funds a low-cost vehicle within the mutual fund schemes.
When investing in markets, the investors need to manage two kinds of risks – systematic and unsystematic risks. Systematic risks refer to the risks of change in portfolio valuation due to adverse economic events, e.g., the Covid-19 outbreak, which led to a strong market correction in March 2020.
Such risks are considered universal to all market-linked investments. On the other hand, unsystematic risk could arise due to poor stock selection, leading to losses in the investment portfolio. Since active funds are involved in active investment strategies, the investors are exposed to both the risks, systematic and unsystematic risks.
In contrast, passive funds don’t offer any flexibility to the fund managers to go beyond the underlying index. As such, the unsystematic risks get eliminated automatically for the investors in passive funds.
Active funds tend to have a higher portfolio turnover ratio, as the fund managers aim to make active investment decisions to generate better returns than the benchmark index.
In contrast, passive funds can be expected to have a lower portfolio turnover ratio since the changes in the underlying index are not that frequent. The fund manager will make the changes in the investment portfolio only when there are corresponding changes in the underlying index.
Investment Options for the Investors
Investors can expect to have a wider choice of mutual fund schemes that are managed actively.
While passive funds have a significant market share in mutual fund AUM (Assets Under Management) in the developed economies, such funds are yet to gain traction in India.
As of August 31, 2021, passive funds, including index funds, ETFs, and Fund of Funds investing overseas, have only 11% share in the industry AUM with an AUM of Rs. 4.12 lakh crores. The net inflows of Rs. 11,592 crores in August 2021 vouch for the steady traction such funds are gaining in India, but passive funds have a long way to go.