Of late, the noise on active investing versus passive investing is gaining ground. We have a place for active investing where the mutual fund managers actively seek higher returns by investing a part of the portfolio allocated to current trends or sectors that are performing well. Active vs passive investing Lets try to understand what exactly are the terms—active investing and passive investing. In active investing, the aim is to deliver a return higher than the benchmarks. In this case, the benchmark can be Nifty 50 or BSE 30 Sensex or BSE 200, depending on the scheme of investments. Here, the mutual fund manager takes a decision on which stock to buy, sell or hold. With the inputs provided by the research desk and in consultation with the Investment Committee (IC), the fund manager takes the investment decision and the duration call. The turnover ratio of stocks in the portfolio can be higher in the case of active management. The returns can offset the cost of turnover if the call of the fund manager goes in line with the market movement, wherein he delivers a return higher than the benchmarks, as stated earlier.
Passive investing is more of a buy-hold strategy in terms of direct equity. For retail investors, there are Exchange Traded Funds, popularly known as ELF, which mirror the benchmark they represent. Say, if the ETF is Nifty ETF, the composition of the ETF will be exactly mirroring the composition of the Nifty, barring the cash holdings, which it would need to keep. The returns in this case would be more-or-less in line with the benchmark it represents. To increase the reach of the capital market, the government recently also announced a Bharat -22 ETF, comprising banks, PSU and SUUTI stocks to speed up its disinvestment programme. Pros & cons Typically, ETFs have lower operating cost, including the management fees. The fund manager basically tracks the index stock and invests according to the composition of the index. It is more transparent, as the investing framework and stock composition is known at the beginning.
So, in this case, you can never get returns in excess of the index. Moreover, even if the portfolio manager has a particular view of the market or a stock, he cannot take any decision as the mandate of the ETF is to mirror the holdings of the underlying benchmark. You find ETF acceptance more in a matured markets as in the US where the opportunity to beat the indices are far less given the very mature level of the markets. Higher operating cost resulting in higher fees to the clients is attributed towards active investing. If the call of the fund manager goes in the direction opposite to the market movement, there can be a sustained period of underperformance (which was noticed in one of the leading funds). But, with patience, the performance can beat the market returns.
Concentrated investments can be undertaken, which is both a plus or minus, depending on the market movement. The skills of the fund manager are effectively put into use and can generate returns ahead of the underlying benchmark indices. Also, effective risk and tax management strategies can be adopted in active investing. Opportunities for active investing is more found in financial markets which are growing such as India or the Far East or Brazil. There is no right approach to investing. All the methods and process are only directions / indicators to an investor to have his cashflow and generate wealth. A combination of both active and passive investing could work well in a country like India, which is slowly accepting the financial markets in a more open manner.
The author is managing partner, BellWether Advisors LLP