August 11, 2022
Mutual Funds are one of the easiest ways to start investing. Mutual fund is an investment vehicle that pools money from different investors to purchase a portfolio of securities. There are two primary categories in mutual funds- Active and Passive Funds.
What are Active Funds?
Active Funds have a dedicated fund manager who makes all the decisions about the securities in the fund with a goal of beating average index returns. Fund Manager looks into a wide range of data for every investment in the portfolio from quantitative to qualitative data, using this information, managers buy and sell assets to generate alpha returns.
Advantages of Active Investing?
- Flexibility: The fund managers have the potential to buy and sell stocks as per the volatility in the market. They aren’t required to follow any specific index. They can buy any stock as per their research.
- Professionally Managed: Instead of researching, selecting, buying, and selling your own investments, you can invest in an actively managed fund and let a professional fund manager do this work for you.
- Generates Alpha: The primary goal of a fund manager is to outperform returns of the index thus generating alpha. The fund manager utilises time and knowledge for market research before buying and selling the securities to generate alpha.
Disadvantages of Active Investing?
- Higher Cost: Actively Managed Funds can have an expense ratio higher than passive funds, as the fund manager charges higher fees to manage the portfolio.
- Higher Risk: These funds get higher returns thus have a higher risk. The manual decision making can be prone to error.
What are Passive Funds?
Passive Funds do not have a dedicated manager who makes the decisions. Instead of actively buying and selling securities regularly, a passive fund’s strategy is to replicate the index. Passive funds invest in the same companies that are part of the index.
Advantages of Passive Funds?
- Lower Cost: The expense ratio in passive funds is comparatively lower to active funds as these funds are only replicating the index, no active fund management is required.
- Increased Transparency: What you see is what you get, it is very clear which securities are in an index fund.
Disadvantages of Passive Funds?
- Lower Returns: Passive funds do not aim at beating the benchmark index. Returns are identical to index or marginally lower due to expense ratios.
- Limited Access: Passive funds are limited to the specific index with no variance for securities.
Investors who want to achieve returns that match a benchmark index, less expenses, may prefer a passively managed fund. But investors who seek the possibility of outperforming the stock market, and who don’t mind the relatively higher market risk, may prefer to buy an actively managed fund. A combination approach can also give the investor a peace of mind to know their passive, long-term strategy is secured with similar to index returns while an active, short-term strategy lets them explore trends with higher returns.
Goal based financial planning requires the right strategy to achieve your desired outcome. Various online wealth management platforms provide recommendations for this selection.
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