Active vs Passive Mutual Funds: Which Should You Choose?

Last Updated on August 21, 2023 at 6:23 am

A mutual fund is a financial instrument that pools money from the investor and invests on their behalf. As mutual funds become more popular, investors face difficulty making choices.

Mutual funds are segregated into two main categories: active and passive mutual funds. If you invest through a broker, the most likely changes are that they will suggest actively managed funds, leading them to more commission.  In this article, I will help you understand the pros and cons of both categories (active vs passive mutual funds) so that you can make an informed decision.

About the author: Salma Sony is a SEBI Registered Investment Adviser and a Certified Financial Planner with 13 years of experience in the financial industry. She is an M.B.A. Finance graduate and has guided 300+ families in comprehensive financial planning with a vision to advise families to achieve financial wellness and peace of mind. She can be contacted via her website: salmasony.com. This is an archive of investment planning articles by Salma.

Salma is a member of Fee-only India, an informal association of flat fee-only financial advisors. Launched in Sep 2017, it helps connect investors with SEBI-registered investment advisors without conflict of interest. Dr M Pattabiraman is a founder-patron of fee-only India.

What is a Benchmark? Simply put, the benchmark is a reference point that helps investors and fund managers assess the fund’s performance relative to a specific index. Benchmarks are used to measure how well a mutual fund is performing compared to a predefined investment strategy.

In active mutual funds, the fund manager aims to outperform the benchmark, whereas in passive mutual funds, the fund manager seeks to replicate the benchmark performance. Let’s understand them more profoundly.

What are active mutual funds? Active mutual funds are managed by professionals (fund managers) who actively manage the fund’s portfolio to outperform a specific market benchmark.

These funds aim to generate returns that surpass the benchmark by making strategic investment decisions based on research, analysis, and the manager’s expertise.
Here is an example of fund, category & benchmark:

• XYZ-1 Equity Fund, Actively Managed – Equity Large Cap Fund,  S&P BSE 100 TRI
• XYZ-2 Equity Fund, Actively Managed – Equity Flexi Cap Fund, S&P BSE 500 TRI
  XYZ-2 Equity Fund,  Actively Managed – Equity Mid Cap Fund,  S&P BSE 150 Mid Cap TRI

So, in the above example, the fund manager of  XYZ-1, XYZ-2 & XYZ-3 equity funds aim to outperform their respective benchmark by making strategic investment decisions based on their research, analysis, and expertise.

How Are Active Mutual Funds Managed?

As the name defines, active mutual funds are managed actively by a team of professionals researching and selecting investments. The managers decide which securities to buy and sell based on their analysis of economic conditions, market trends, company financials, and other relevant factors.

It is important to note that each mutual fund has its objective, and all the fund manager’s decisions align with the fund objective.

What Are Passive Mutual Funds?

Passive mutual funds are also well-known as index funds and are not actively managed. Here the fund manager aims to replicate the benchmark. Passive fund managers buy and hold securities relevant to a benchmark index. Passive funds follow a more systematic and rules-based approach.

How Are Passive Mutual Funds Managed?

The primary goal of passive funds is consistently tracking the benchmark’s performance over time. While slight variations may occur due to factors like tracking error and fund expenses, the aim is to mirror the benchmark’s returns clos

Pros and Cons – Active vs Passive Mutual Funds

Active Funds – Pros and Cons

Pros:

• Active funds have the potential for higher returns due to active management and skilful decision-making.
• Active funds have the flexibility in portfolio adjustments to grab on market opportunities.

Cons:

• Higher management fees and operational expenses (expense ratio).
• Higher risk of underperforming the benchmark.
• Dependence on the fund manager’s expertise.

Passive Funds – Pros and Cons

Pros:

• There are lower management fees and operational expenses (expense ratio) than active funds.
• Reduced the risk associated with the fund manager’s decisions.
• Reduced dependency on individual manager decisions.

Cons:

• Passive funds have no potential for outperformance beyond the market index.

Which Fund Should You Choose – Active vs Passive Mutual Funds?

Here are two critical factors you must consider apart from your financial goals, investment time horizon and risk appetite.

1. Mindset: If you want to take market risk but have a passive investment mindset, consider investing in an index fund. However, aggressive investors can opt for active funds.
2. Time commitment and personal involvement: If time commitment concerns monitoring your portfolio, you must consider a passive mutual fund. However, getting expert help for your financial planning can go with a balanced approach (mix of active & passive funds).

Remember: Index / passive funds are subject to market risk, just that risk associated with fund managers’ decisions is eliminated. So, monitoring your goals is essential even if you opt for passive mutual funds.

Conclusion

The active vs passive mutual funds debate revolves around whether active fund managers can consistently beat the benchmark after accounting for their higher costs.

Passive funds, such as index funds, track a benchmark and aim to match its performance with lower fees. The debate centres on whether the higher fees of active funds are justified by their potential for higher returns.

My view is that choice between active and passive funds is not one-size-fits-all. It’s essential to consider your financial goals, investment time horizon, and risk appetite, then diversify your investments that include active and passive funds personalized to your investment goals and risk tolerance classes to manage risk effectively.