Ever since passive investing came into the picture, everyone has been debating whether an active investment is better than a passive investment.
Today, let’s understand the difference between active and passive investment, its pros and cons and try to find a solution to whether an active or passive investment would work for you.
What is Active Investment?
Active investing is where your fund manager puts endless efforts into analysing multiple companies and picking the best ones. The goal of an active fund manager is just to beat the benchmark index. Hence, the fund manager and his team believe in finding the best opportunities in the market, and if they find a better stock, they switch a not-so-good stock with a stock which has the potential to generate higher returns.
So, overall, the fund manager and research analysts put in a lot of effort to pick stocks with the potential to generate returns. Now, their job does not end here. Once invested in a fund, they must track and monitor the stocks. They book profits and shuffle their portfolio from time to time.
An active fund manager can use his/her expertise to decide which stocks to pick and which to let go of.
What is Passive Investing?
Passive investing is just the opposite of active investing. In an active investment, the fund manager aims to beat the benchmark. But in passive investment, the fund manager does not have to rack his head to beat the benchmark. The goal of a passive fund manager is to simply copy the allocation of the benchmark and deliver the same returns as the benchmark. He/she does not have to make active decisions or analyse stocks.
For example, if a passive mutual fund has Nifty 50 as its benchmark, then the fund manager will invest in the stocks of the benchmark Nifty 50. Moreover, if the weightage of Reliance Industries is 10% in Nifty 50, then the fund will invest 10% of your funds in Reliance industries. The fund manager does not have a say in investing 11% or 9% in Reliance Industries.
At the end of the day, if the return of Nifty 50 is 2%, your fund will also offer a return of 2%.
Cons of Active and Passive Funds
- Expense Ratio
Nothing in this world is for free. Both active and passive funds charge some expense ratio for managing your fund. But, the one putting in more effort will undoubtedly charge you more. Hence, active funds have a high expense ratio.
As per SEBI’s mutual fund regulations, an actively managed fund can not charge an expense ratio of more than 2.25%.
But when it comes to passively managed funds, the fund manager does not have to put much effort; hence it charges a lower expense ratio.
- Fund Manager Bias
In an actively managed fund, because the fund managers have the freedom to pick stocks, they can act on their conviction on a stock. The conviction may later prove to be profitable or loss-making. So, what happens with your portfolio totally depends on the fund manager’s decisions.
But, in a passively managed fund, even if the fund manager knows that the stock in the index is not fundamentally strong, he/she still cannot remove the stock from the portfolio because it exists in the index. Historically, stocks like Satyam computers have eroded investors’ wealth, but even if the fund manager suspects the stock, they cannot remove it from the portfolio.
Where Should you Invest – Active or Passive Fund?
Ideally, there should be a healthy mix of both in your portfolio. If you are investing in an actively managed fund, invest in a passively managed fund as well. By doing so, you will benefit from both the investment option in your portfolio.
Moreover, when you invest, you must always analyse your risk appetite before investing. Accordingly, choose which fund you wish to invest in.
*The stocks mentioned in the article are for informational purposes. This is not investment advice.