Understanding Active vs. Passive Mutual Funds in India

Introduction

There's a lot of buzz around index funds in India. A lot of people are saying that index funds are the future of mutual fund investment, particularly the passive style of mutual funds.

So, what is a passive style of mutual fund, and how is it different from the active mutual fund?

Hello, friends! My name is Ankit Singh, and In this article I have explain everything about the Active and Passive Mutual Funds in simple language

As an investor, when you invest in a mutual fund, you would find various types of mutual funds.

For example, on the basis of fund selection, you have

• equity mutual funds - invest in stocks
• debt mutual funds - invest in bonds
• hybrid mutual funds - invest in a mix of both stocks and bond etc

Now, with an equity mutual fund, you have various sub-categories like large cap, mid cap, small cap, flexi cap, multi-cap, etc.

But there is another categorization of mutual funds based on the mutual fund investment style. Within that, you have two types of mutual funds: active mutual funds and passive mutual funds.

If you want to invest in an equity-based mutual fund, you can choose between the active and passive styles of mutual funds.

What is Active vs. Passive Mutual Fund?

Active mutual funds are those that are actively managed by the fund house, where the fund manager actively buys and sells the stocks in the portfolio of the mutual fund to generate high returns. The ultimate goal of each mutual fund is to beat the benchmark.

So, what is the benchmark?

Benchmark is the criteria you can use to compare the performance of a mutual fund.

For example, let's say in the last one year your mutual fund has given around 12% return.

Now, what can you infer from that? Did it perform well or not? For that, you need to compare it with the benchmark.

If the benchmark has given a 15% return in the last one year, then your mutual fund has not done well.

But let's say your mutual fund has given a 5% return in a year, but the benchmark has given a 3 percent return. In that case, your mutual fund has done well as it was able to beat the benchmark.

Benchmark is very important. Some examples of benchmarks are Sensex, which is a benchmark for those mutual funds that invest in the top 30 companies of India, and

Nifty 50, which is a benchmark for those mutual funds that invest in the top 50 companies in India. Likewise, you have Nifty 100 as a benchmark, Nifty 500 as a benchmark, and so on.

When you invest in a mutual fund, your mutual fund house charges a fee somewhere in the range of around 0.5% to 1.5% to actively invest your money in the stock market, where the fund manager would keep buying and selling the stock frequently.

Here, we are talking about the direct option; the regular option would have an additional commission for the agent. In that case, the expense ratio would be between 1.5% to 2.5%. The ultimate goal of each active mutual fund is to beat the benchmark.

But what if the active mutual fund is not able to beat the benchmark? In that case, isn’t it better to invest directly in the benchmark? Why pay a high expense ratio? That's where your passive mutual fund comes into the picture.

Passive mutual funds exactly replicate the benchmark. For example, if there's a passive mutual fund that replicates Nifty, then the passive mutual fund would hold each stock of Nifty in the exact same proportion.

So, if Reliance has got a weightage of 12% in Nifty, then out of ?100, ?12 of your money would be invested in Reliance.

If HDFC Bank has a 7% weightage, then 7% of the money would be invested in HDFC Bank, and likewise.

I hope now you understand what an active mutual fund is and what a passive mutual fund is. Some examples of index funds include HDFC Nifty 50 Index Fund, SBI Nifty 50 Index Fund, UTI Nifty 50 Index Fund, etc.

Likewise, there are various index funds that replicate Sensex, Nifty Next 50, and other indices.

Difference Between Active vs. Passive Mutual Funds

Now that you understand what an active mutual fund and a passive mutual fund are, let’s understand the difference between active and passive mutual funds.

The first difference is that in an active mutual fund, the fund manager actively buys and sells stocks from the portfolio,

whereas in a passive mutual fund, the fund manager simply replicates the stocks in the exact same proportion based on the benchmark it replicates.

The second difference is that in an active mutual fund, the goal of the fund manager is to beat the benchmark in terms of returns,

whereas in a passive mutual fund, the goal of the fund manager is to fetch the same return as the benchmark.

The third difference is that in an active mutual fund, the fund charges an expense ratio somewhere in the range of 0.5 to 1.5% for direct plans,

whereas index fund expense ratios are between 0.05% to 0.3%.

When it comes to active vs. passive mutual funds, there’s a lot of debate over whether active funds are better or passive funds.

Both styles have their own set of supporters. The supporters of active mutual funds say that in a country like India, where there is a lot of inefficiency, meaning there are a lot of companies that can potentially generate higher returns, it makes sense to invest in an active mutual fund where the fund manager would actively buy and sell the right stock to beat the benchmark.

However, the supporters of passive mutual funds say that in the long term, your active funds can’t beat the benchmark by actively buying and selling stocks, and the fund houses are charging high fees to mint money.

Hence, it is better to simply replicate the index like Sensex or Nifty for long-term investment.

On top of this, passive funds charge a very low expense ratio, as low as somewhere between 0.1% to 0.2%, which means the profits are passed on to the investor by deducting just 0.1 percent to 0.2 percent in fees, compared to active funds that charge an expense ratio in the range of 0.5 to 1.5 percent.

In fact, the new index fund of Navi Nifty 50 Index Fund has an expense ratio of just 0.06 percent. That's an almost negligible fee.

If you look at developed markets like the US, most people invest via index funds as the active ones are not able to beat the benchmark, and the index funds are available at a very low cost.

But in a developing country like India, it is still debatable if the index fund, that is, the passive fund, can beat the active funds or not. However, if you compare the historical performance, around half of the large cap active funds are not able to beat the benchmark.

It means there are high chances that you might end up investing in active mutual funds with high expense ratios that are not even able to beat the benchmark in the long term.

How to Shortlist an Index Fund?

To shortlist an index fund, you need to look at two major parameters:

• Expense ratio and
• Tracking error.

At the end of the day, since an index fund simply replicates the benchmark or index, the return should also be the same as that of the index. However, the index fund doesn't give the exact return as that of the index. It is mainly due to two reasons.

The first reason is because the index fund charges a small fee, that is, an expense ratio, and that gets deducted from the return.

The second reason is due to tracking error. Now, what is tracking error? Tracking error is basically the error in replicating the index.

For example, when the fund manager replicates the index, the fund manager also needs to reallocate the fund in case of the addition or removal of a stock from the index.

For example, if Divis Labs enters into Nifty 50 and Zee exits from Nifty 50, the fund manager would have to invest in Divis Labs and exit from Zee. Likewise, the fund manager needs to keep some cash handy in case of redemption from investors.

Also, fund managers need to keep investing the money in the same proportion based on the amount received from the investors. Hence, due to all these factors, there is a tracking error, and the returns from index funds are slightly lower than the index.

So, if you want to invest in an index fund, you need to ensure that the

• Index Fund has a lower expense ratio and
• Lower Tracking error.

Should you Invest in Active Mutual Funds or Passive Mutual Funds?

Now, the most important question is, should you invest in active mutual funds or passive mutual funds?

Well, it depends upon your investment style. If you believe that fund managers would be able to beat the benchmark, you can choose to invest in active mutual funds.

But make sure that the fund has a good track record of beating the benchmark. Otherwise, it is better to invest in passive mutual funds like index funds with a low expense ratio and low tracking error.

Having said this, it doesn’t mean that active mutual funds are bad and everyone should invest in index funds.

In a country like India, there is still a lot of scope for fund managers to beat the benchmark in the mid cap and small cap category.

Hence, if you want to invest in active funds, you should invest in mid cap and small cap active funds, whereas in the large cap category, it is better to invest in an index fund.

So, in a nutshell, I would suggest investing in an index fund in the large cap category, while in the mid and small cap categories, you can invest in actively managed mutual funds.

I hope you found this article useful and it give you a clear understanding of what an active and passive mutual fund is and how they are different from each other. I hope now you would be able to choose between an active vs. passive mutual fund.

Conclusion

"In conclusion, understanding the difference between active and passive mutual funds is crucial for making informed investment decisions. While active funds offer the potential for higher returns by attempting to outperform the benchmark, they come with higher fees and risks.

On the other hand, passive funds, particularly index funds, provide a cost-effective way to match market returns with lower expense ratios and tracking errors. As India's mutual fund landscape evolves, choosing the right investment strategy, whether active or passive, depends on your financial goals and risk tolerance.

Remember, for long-term wealth creation, balancing your portfolio with a mix of active and passive funds can be a wise approach.

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