What are Passive Funds And How are They Different From Active Funds?

3 min read

The world of the stock market  reminds me of a very old saying which has almost stood true in every aspect of life including the stock market, “slow and steady wins the race”. Like an old wine, the longer an investor holds his investments, the longer the investments have time to mature helping with decent returns.

Passive investing is one of the most popular types of investing. It is a long-term strategy for building wealth by buying securities that mirror stock market indexes, then hold them  for a long term.

Passive Funds

A passive fund is a type of fund that religiously tracks a market index to allow a fund to fetch maximum gains. The fund manager does not actively choose what stocks the fund will be composed of, which makes it completely opposite of the active fund, and it makes passive funds easier to invest in than active funds. Also, passive funds are a good way for a beginner investor because you do not need to research and worry about the best performing fund.

Benefits of Passive Investing

  1. Lower Costs – Passively managed investment products like ETFs, or index funds tend to have lower expense ratios as compared to actively managed funds. This is because the investment team has almost negligible role to play in terms of selection of stocks and determination of investment timing considering the need of only tracking the changes in the composition of benchmark indices. Consequently, the fund management charges and transaction costs are minimal, thereby resulting in lower costs for the investors.
  1. Diversification – Since the benchmark indices are constructed to have an overall market representation, comprising different sectors and segments of the market, investing with a passive investment strategy passes the same benefits of diversification across the market segments through a single investment product.
  1. Elimination of unsystematic risk – Systematic risk is the risk of market movements due to changes in the macroeconomic indicators like economic growth, current account deficit, etc. Unsystematic risk refers to the risk other than the systematic risk. In other words, it is the risk of selection of wrong investment products or improper timing of investments in the mutual fund scheme. Since the passive investment strategy does not render such flexibility to the fund managers, such risks stand mitigated for the investors.

Passive funds for new investors

Choosing the right investment fund for your portfolio can be a tedious and challenging task for beginners, especially if you do not have an expert by your side to guide you through. You need to first understand your portfolio requirements and then look for the right fund by studying fund style, performance cycles, risks, etc., and continue to review and track the fund consistently. For beginners, passive funds like index funds are a simpler choice. Index funds are simple, easy to choose and track, available at a low-cost, and offer market linked returns.

Passive funds for seasoned investors

Investors who already have a portfolio of active funds can add passive funds to complement their portfolios and potentially enhance risk-adjusted returns. The addition of passive funds to the portfolio may reduce some risks of underperformance that may come through in an active fund in the short- term due to different investing styles.

Active vs Passive Funds

There are significant differences between active and passive funds, such as management style, cost, tax-efficiency, and performance goal.

  1. Management style: The primary difference between active vs passive funds is how the funds are invested and managed. For example, an active fund manager has some discretion in security selection, as well as the timing of trades. In contrast, most passive fund managers can only buy and hold the securities that are in a benchmark index, such as Nifty. Index fund managers must also passively hold the securities at roughly the same weighting as the index. Some active funds might also hold only Nifty stocks but their managers can use discretion in which stocks to buy, which to avoid, and how to weigh the holdings.
  1. Costs: Actively-managed funds generally have higher costs, measured by an expense ratio, than passively managed funds. This is because active management generally requires more research, analysis, and trading compared to passive management by a dedicated experienced analyst or financial advisor.
  1. Tax-efficiency: Since actively-managed funds tend to have higher turnover (more buying and selling of securities in the fund), they tend to generate more capital gains distributions to shareholders compared to passively-managed funds. 
  1. Performance goal: Actively-managed funds generally attempt to outperform a broad market index; whereas passively-managed funds generally attempt to match the performance of a benchmark index, less management fees. For example, an actively-managed large-cap stock mutual fund would typically attempt to outperform the S&P 500. A passively-managed S&P 500 index fund would attempt to replicate, less fees, the performance of the S&P 500 index.

Investors who want to achieve returns that match a benchmark index, less expenses, may prefer a passively-managed index fund. Deciding whether or not to invest in active funds vs passive funds is a personal choice and can depend on multiple considerations, such as an investor’s unique risk profile and financial goals. Some investors combine active and passive styles within a portfolio, while others may choose neither and invest in a completely different security type.

According to market experts, there is no right or wrong choice between investing in active and passive funds. If you prefer minimal risks, go for a passive fund that gives moderate returns.  If you want high returns, assess your risks, and invest in active funds. You can also invest partially in both types of funds.

If you are a beginner or a seasoned investor, ShareIndia is a good place to research and compare funds based on returns, risk levels and your financial goals. Click here to contact our ShareIndia experts.

Disclaimer: Any Advice or information in the post is a general advice for education purpose only and is not responsible for generating any trading strategy for anyone, please do not trade or invest based solely on this information.

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