A mutual fund (MF) is an investment in a set of companies, bonds, or both. MFs are categorised based on the types of companies invested in, the sector, risk profile, lock-in period and the way the funds are managed. Depending on how aggressively the funds are managed, MFs are categorised as either active or passive.
Active funds require a proactive approach from the fund manager. This means selecting the right sector, the right companies, the equity-debt proportion and factors such as the size of companies, whether they are domestic or multi-national, etc. For example, a small-cap fund, which invests in firms with low market capitalisation, would be actively managed. The fund manager would include or exclude small and emerging companies based on their growth prospects.
In contrast, passive funds follow a stock market index and don’t require active management. They are also known as index funds. They mirror a specific index and the returns reflect the change in index value over a period of time. An example would be an index fund tracking the BSE Sensex, which comprises stocks of 30 blue-chip firms in the country.
An index fund is not dependent on the composition of firms in the index. It gains when the Sensex gains and falls when the Sensex drops.
Active funds: Key features
Flexibility of portfolio formation: In active funds, the fund manager selects the companies to be included. If he later feels that the growth prospects of a company have diminished, he can remove it from the fund. Similarly, if he identifies a new company with good growth prospects, he can include it in the fund.
Wide range of options: Fund managers can create schemes based on customised parameters. For example, a fund manager may feel that the government might cut interest rates on a sustained basis for a few quarters, whereupon the fund house may launch bond funds to take advantage of that. Similarly, a fund house may see, say, Asia-Pacific countries experiencing a surge in growth in near future — it may respond with a fund specific to Asia-Pacific companies.
High expense ratio: The only disadvantage of active funds is the expense ratio, which includes fund management fee and other charges. It can be as high as 1.5-2.5%, which eats into your returns. This means if the fund generates 12% in a year, you may get only 10%.
Passive funds: Key features
No portfolio flexibility: One of the disadvantages of passive funds is that even if a company is not giving good returns for sustained periods, the fund manager’s hands are tied. Since the company is part of the index, the fund will have no option but to retain the company.
Limited choices: There are only a few funds, such as those mirroring the Nifty, Sensex, Junior Nifty, Banking index, etc. From time to time, funds tracking a specific sector, such as manufacturing or software, may emerge, but these are few and far between.
Low expense ratio: The biggest advantage of passive funds is the low expense ratio, which is 0.5-1%. The reason is obvious — fund managers do not have to attend company earnings calls or spend time and effort in studying the right firm and right sector, or undertake the various other tasks that an active fund manager has to.
All that an index fund does is follow an index and duplicate its return with a margin for expense ratio. For instance, if the Sensex moves from 20,000 to 23,000 in a year, the return is 15%. For a fund tracking the Sensex, since the expense ratio is 1%, the investors of that fund would receive 14% return in the same year.
What you should do
Index funds definitely deserve consideration, if not a place, in an investor’s investment portfolio. Usually, they are not marketed well because of the low fees associated with them. However, information on index funds is available with broking and financial news websites.
As index funds invest in indices comprising companies, they are a high-risk investment, probably as risky as any other equity MF. Like other equity funds, index funds do well in the long run because the overall market does that as well.
Find your voice
* In active funds, the fund manager selects the companies. If he later feels the growth prospects of a company have diminished, he can remove it. In passive funds, however, even if a company is not doing well, the fund manager’s hands are tied
* In active funds, managers can create schemes based on their projections of how a certain sector or theme will play out. On the other hand, in passive funds, choices are limited to mirroring the Nifty, Sensex, Junior Nifty and a few other indices
* Expense ratio for active funds can be as high as 1.5-2.5%, eating into returns. Passive funds, however, charge a low expense ratio, usually 0.5-1%
The writer is CEO, BankBazaar.com