Explained: What is the difference between active and passive mutual funds?

When it comes to investing in mutual fundsAn investor must decide whether to choose active or passive funds. Both types of funds offer different approaches to managing investments and understanding their differences can help an investor make an informed decision that fits his or her financial goals.

What are Active Funds?

Active funds are mutual funds managed by professional fund managers who make active decisions about which stocks, bonds, or other securities to buy or sell. The goal of an active fund is to outperform a specific performance. benchmark index through strategic investments and market timing.In other words, in actively managed funds, the fund manager has the flexibility to choose the investment portfolio, within the broad parameters of the plan’s investment objective. As this increases the role of the fund manager, the operating expenses of the fund become higher. Investors expect actively managed funds to outperform the market.

Key features of active funds:

1. Professional management: Active funds are managed by experienced fund managers who use research, analysis and market knowledge to make investment decisions.
2. Higher rates: Due to the hands-on approach to portfolio management, active funds typically have higher management fees and expense ratios compared to passive funds.
3. Outperforming potential: The main objective of active funds is to outperform the market or a benchmark index. If the fund manager makes sound investment decisions, active funds can deliver returns that are above the market average.
4. FlexibilityFund managers have the flexibility to adjust the portfolio based on changing market conditions, economic trends or specific company performance.
   
   
5. Higher risk: While active management aims to achieve higher returns, it also entails higher risks, as the success of the fund depends largely on the manager’s decisions.

What are passive funds?

Passive funds, also known as index funds, aim to replicate the performance of a specific market index. Rather than trying to outperform the market, passive funds seek to match the benchmark’s returns.

A passive fund tracking the BSE Sensex index would buy only those stocks that are part of the composition of the BSE Sensex index. The proportion of each stock in the fund’s portfolio would also be the same as the weightage assigned to the stock in calculating the BSE Sensex index. Therefore, the performance of these funds tends to mirror the index in question. They are not designed to outperform the market. These funds are also called index funds. Since the portfolio is determined by the index itself, the fund manager has no role in deciding on the investments. Therefore, these funds have low running costs.

Main features of passive funds:

1. Index trackingPassive funds invest in the same securities that make up a specific index, reflecting their performance.
2. Lower rates:Since passive funds require less hands-on management, they generally have lower fees and expense ratios compared to active funds.
   
   
3. Market performancePassive funds aim to match the performance of the benchmark index, not beat it. Investors can expect returns that closely track the performance of the index.
4. Minor risk: Passive funds are considered lower risk compared to active funds as they are less dependent on individual investment decisions and more on the overall market.
5. TransparencyPassive funds are more transparent as their holdings are public and change only when the index they track is rebalanced.

Difference between active and passive funds

1. Management style:

• Active funds: Managed by professional fund managers who make active investment decisions.
  
  
• Passive funds:It managed to reflect the performance of a specific index with a minimum of operations.

2. Costs:

• Active funds: Higher management fees and expense ratios thanks to active management.
• Passive funds:Lower fees due to the automated nature of index tracking.

3. Performance goals:

• Active Funds:Try to outperform a benchmark index, potentially offering higher returns.
• Passive Funds: The aim is to replicate the benchmark, providing returns that match the market.

4. Risk:

• Active Funds:Higher risk due to dependence on fund manager decisions and market timing.
• Passive funds:Lower risk, as performance is linked to the overall market and not to individual stock selection.

5. Investment horizon:

• Active Funds:It may be more suitable for investors with a higher risk tolerance and a longer investment horizon seeking potentially higher returns.
• Passive funds:Ideal for investors who prefer a stable, long-term approach with consistent returns.

Which one should you choose?

The decision between active and passive funds depends on your investment objectives, risk tolerance and preference for management style.

• Choose active funds if: You are looking for potentially higher returns and are willing to pay higher fees and take on more risk. You believe in the ability of an expert fund manager to outperform the market.
• Choose passive funds if: You prefer a low-cost, long-term investment strategy with returns that mirror the market. You are more risk-averse and prefer the predictability and transparency of index investing.