Active Investment vs Passive Investment: What is the Difference Between Active and Passive Funds?

Mutual funds are quickly becoming a popular investment among young Indians. Before you start investing, you should know that mutual funds can be categorized into active and passive funds, depending on how they are managed.

In the case of active funds, a fund manager who takes a hands-on approach to managing the assets of the fund. Conversely, passive funds are not intensively managed by fund managers.

Keep reading this article to learn the differences between active and passive mutual funds, their pros and cons, and which one is the best fit for you.

What are active funds?

Active funds are actively managed by fund managers, who are dedicated market experts and analysts. Fund managers aim to generate revenue by outperforming a specific index called the benchmark.

One example of active funds is equity funds. The fund manager of an equity fund makes all decisions about the underlying stocks after evaluating the market performance, economic conditions, and the individual performance of each asset. Other popular categories of mutual funds like debt and hybrid mutual funds are also active funds.

What are passive funds?

Passively managed funds, or passive funds, do not involve the active participation of a fund manager.

One example of passive funds is Exchange-Traded Funds (ETFs.) ETFs are designed to recreate the pattern of a given stock index, and the fund manager simply maps the movement of that index.

No one actively makes decisions about buying and selling assets in passive funds. In case there is any rejig in the benchmark index; the fund manager simply makes the same adjustments to his fund to mirror its performance, and later buy or sell securities depending on their index performance. Then, the returns of the index translate into the returns of the ETF.

Additional Read:5 Investment Rules that can help you sail through this year

The pros and cons of active funds

Active funds can generate higher returns than a pre-selected benchmark. Fund managers can choose to increase or decrease the amount invested in each stock, or release specific holdings or market sectors when risks get too high. Thus, active funds are flexible and have better risk management.

On the downside, the decision-making process is prone to human error, there is no guarantee that they will generate higher returns or be entirely risk-free. When investing in active funds, you also have to pay a fee, known as the expense ratio, for the fund manager's expertise and decision making. Thus, active funds are more expensive

The pros and cons of passive funds

Passive funds have minimal fees because investors need not pay for a market analyst's expertise. As per SEBI regulations, the expense ratio for ETFs can be at most 1%. So, they are less expensive than active funds.

However, they always generate moderate returns. The returns may be less than or equal to the benchmark's returns but never higher. 

Additional Read: Understanding anchoring bias and its influence on your investment patterns

Which option should you choose?

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, Tata Capital's Moneyfy app is a good place to start. You can research and compare funds based on returns, risk levels and your financial goals. Download now and start creating wealth today!