What are Active Funds and Passive Funds?

 

Mutual fund investments due to their dynamic nature are often managed by fund managers. By this mutual fund portfolio management, we mean how fund managers buy and sell the underlying assets (equity, debt, gold, etc). Mutual funds are usually managed either actively or passively. The basic difference between active and passive funds is in active fund management, the fund managers are more involved in the decision making. Basically in active fund management, fund managers look after which Stock or Bonds go in and out of the portfolio and when. In passive funds, the fund manager does not have the freedom to drive the movement of the underlying assets.

 

Let’s understand these funds more in-depth.

 

What is an actively managed portfolio?

 

The following funds are actively managed funds – equity mutual funds, debt mutual funds, hybrid funds, or fund of funds. To understand the role of a fund manager, let’s pick an example of equity mutual funds. In this, the fund manager decides which stocks will go in and out of the fund by analyzing the larger markets, economies, and the individual performance of the stock. 

 

Furthermore, the fund manager can also decide whether the existing stocks will remain in the same quantity if the investment fund is increased or decreased.

 

To summarise, a fund manager in an actively managed portfolio has a lot to do with the fund’s performance. This is applicable to all types of active funds.

 

What is a passively managed portfolio?

 

Moving ahead, let’s also understand the role of a fund manager with a passive fund example,i.e. ETFs (Exchange Traded Funds). In an ETF, it tracks the movement of an index. The index performances are translated into ETF returns. The difference in the returns could be due to reasons such as expense ratio charges, management fees, etc. 

 

Pros and Cons of Actively managed funds

 

Pros:

• Professional Management: As we know that in actively managed funds the role of the fund manager is substantial. This helps the investor to make a wise investment decision while the fund manager does the research and analysis work for you. 
• Performance potential: The actively managed funds tend to outperform a broad index market. But its outperformance is also subjected to higher risks. 

Cons:

• Higher costs: Active funds have higher expense ratios (1% or higher). Also, some funds have other charges like loadings.
• Tax inefficiency: Since in actively managed funds a fund manager frequently buys and sells leading to increased capital gains that are taxable, these funds fail to save taxes as compared to passive funds. 

 

Pros and cons of passively managed fund

 

Pros:

• Lower costs: Since the operational costs are lower in passive funds, expense ratios are also low. This means that the investor has the advantage of keeping more of the fund’s returns over time.
• Tax efficiency: Within the index funds there is less buying and selling of the fund. This translates into a lesser capital gain contribution.

Cons:

• Lack of flexibility: Passive funds track an index that can hold the securities in the same benchmark index. This leads to reduced flexibility as the investor is unlikely to see returns that outperform the index.
• Forced selling/ Forced buying: If investors panic and withdraw their monies from passive funds, the fund manager will have to indiscriminately sell portions of all holdings, even those that may appear severely undervalued.

 

Bottom line

If the investors are looking forward to higher returns, higher risks, and dynamic investment then active funds are beneficial. But if the investors are comfortable with relatively less returns than active funds, lesser expense ratios may prefer passive funds. 

 

At Khasnis Prime Wealth, we leverage our expertise to research, analyze and understand what is best for our clients. We help you to choose the right mutual fund that makes your wealth creation journey a fruitful one.