Pros And Cons Of Active And Passive Funds

Investing has become more intense than ever, there are many new options with a complex risk-return framework which make it even more difficult to make the right choice based on your needs. Among the many investment options, we also have the option of investing in passively managed funds and actively managed funds. Although the name is indicative of the nuances of the investment option, we look at the workings of these funds and the pros and cons of investing in them.

What are Passive Funds?

Passive funds as indicative are passively managed mutual funds, the scheme mimics the indices and the returns are in line with that of the index. There is no effort to generate alpha as the objective is to get returns in line with that of the market. Passive investing is a style that aligns well if you are looking at staying invested over the long term. Among the many benefits of passive funds, here are a few:

Pros of Passive Funds:

1. Low transaction charges: These funds are not tactically realigned to gain upside based on market direction. This reduces the transaction cost significantly. Further, the fund manager is not burdened to generate alpha, and hence, the contribution of the fund manager is also relatively less. All these factors contribute to a lower expense ratio for these funds.
2. Increased transparency: Since passive funds typically mimics the indices, there is absolute transparency on the portfolio strategy of the passive fund.

Cons of Passive Funds:

1. Does not take advantage of market opportunity: Passive funds follow benchmark index regardless of market conditions and therefore, many times they miss the lucrative opportunities that could facilitate the generation of super-normal returns.
2. Low Returns: These funds generate return in line with benchmark as they hold portfolio similar to benchmark and therefore, they can never generate big alpha.

How to invest in passive funds?

One of the most popular categories of passive funds is the Index fund, the Index mutual funds mimic the respective index and offer returns similar to that of the index. The risk profile is also aligned with that of the specific index. You may invest via lumpsum or SIP (systematic investment plan). When compared to active funds, the risk profile of passive funds is much lower. Using the SIP route for investing will lower the risk even further.

TATA Nifty 50 Index fund is one such fund that aims to mimic the holding of Nifty 50 and provide returns in line with the indices. These types of funds are ideal for long-term financial goals such as retirement planning or children’s education.

What are Active Funds?

An active fund is actively managed by the fund manager, the fund manager has the objective of surpassing the returns generated by the benchmark indices. The fund manager is also required to conduct the workings of the fund in such a manner that its performance is better than that of its peers. The fund manager is always actively scouting for investment opportunities that will help in the outperformance of the fund being managed. Alpha is generated by exposing the portfolio to various factors which contribute to the generation of returns. Often fund managers may use the momentum style of investing to invest in counters which are on an uptrend, the focus is on investing in winners as against the losers. The Fund manager along with his team considers multiple factors such as company fundamentals, economic trends, and macro-economic factors when making investment decisions that would benefit the investor and aim to generate higher returns. Following are the benefits of investing in active funds.

Pros of Active Funds:

1. Professionally and proficiently managed: These funds are managed by highly competent professionals who have the necessary expertise and knowledge.
2. Probability of higher returns: Since it is being actively managed, the fund manager is always scouting for opportunities which will facilitate the optimisation of returns.
3. Market timing: Actively managed funds are always scouting for opportunities in the market to help optimise returns, if done right, these realignments could generate super-normal returns.
4. Active risk management: Fund managers of active funds makes changes to the portfolio based on the changing market conditions. Thus, they are able to mitigate the financial risk and maximise the returns of investors.

Cons of Active Funds:

1. Not always favourable: The decision made by the fund manager, although backed by sufficient research may still go wrong due to unforeseen circumstances.
2. Could be detrimental in short term: Like all other equity investments, investing in actively managed funds should also be with a long term. In case, you choose to look at it within the short term, it may often backfire especially so if the timing does not work in your favour.
3. Higher transaction costs: Since the fund is realigned often, the transaction cost would be higher.
4.  Risk: Since these funds fetch higher returns, the risk associated is also higher compared to passive funds. This is because man-made decision-making processes may be prone to error.

How to invest in active funds?

You may invest via lumpsum or SIP (systematic investment plan). When compared to passive funds, the risk profile of active funds is much higher. Using the SIP route for investing will lower the risk even further.

Difference between Passive and Active Funds

In a nutshell:

As discussed above, both active funds and passive funds have their pros and cons. Therefore, the choice of type of mutual fund should be always guided by your investment goals and risk appetite. Typically, a conservative investor could choose a passive fund as they provide the opportunity to participate in the market without frequent tactical realignment.

One should ideally look at a portfolio that combines allocation between actively managed funds and passively managed funds to generate maximum returns and have a cost-effective investment strategy. You can always reach out to experts at TATA Capital Wealth who can guide you in choosing the fund most suited for your needs.