A mutual fund is an investment vehicle that brings together money from multiple investors and uses it to invest in a variety of financial assets like stocks, bonds, government securities, and money market instruments. Investing in a mutual fund is like hiring a skilled and knowledgeable driver for your vehicle. These drivers of your money, or fund managers, have the expertise to navigate the market on your behalf.
While the Indian mutual fund industry is growing at an incredible rate, with over 2000 schemes available today, many times investors are confused about the difference between active and passive mutual funds. This article explains the differences between the two types of funds that you should know before investing.
Active Funds
Active mutual funds are schemes that are actively managed by the fund manager. In this, the fund manager actively buys and sells the underlying assets (like equity, debt, gold etc.) with an aim to beat the benchmark index the fund is tracking. The fund manager has more involvement in the decision-making in active funds. S/he selects the stocks/assets for the fund’s portfolio based on a strategy aimed at generating higher returns than the index.
However, as fund managers are involved in decision-making, active mutual funds have higher costs attached to them in the form of higher expense ratios.
Also Read: Direct Plan vs Regular Plan: The difference you should know before starting SIP in Mutual Funds
Passive Funds
Passive funds, also known as index funds, do not involve the active participation of a fund manager. In this approach, the fund invests money in the companies represented in an index such Nifty50 in the same proportion as the company’s representation in the index. The higher the index return, the higher the return from the passive fund tracking it.
In passive funds, there is no direct involvement of the fund manager in decision-making as to how much to invest or when to invest in stocks represented in an index. The passive, or index fund, thus generates market returns in accordance with the index.
Active vs Passive Mutual Funds
| Feature | Active Funds | Passive Funds |
| Management | Fund manager tries to beat the market | Fund tracks a specific market index |
| Expense ratio | Higher | Lower |
| Potential for returns | Higher (but not guaranteed) | Lower (but more consistent) |
| Risk | Higher | Lower |
| Best for | Investors who want to try to beat the market | Investors who want to track the market without trying to beat it |
What to choose?
The choice between active and passive funds has always been a topic of great confusion among retail investors. However, studies have shown that in the long run, passive funds may provide similar returns to active funds. But in the medium term, specifically 1 to 3 years, active funds tend to show higher returns compared to passive funds.
Before investing, it is important to keep in mind that active funds often have higher cost ratios. The ideal fund in which you can invest depends on your unique investing objective and risk appetite. An active fund may be a suitable choice for you if you are willing to take on a little bit more risk and want to try to outperform the market.
However, a passive fund may be a better option if you are more cautious about your investment returns and the costs involved. That said, it is also important to consult a certified and registered investment advisor to choose a fund based on your financial goals and risk appetite.
This article has been written by Nimmagadda Deeraj, an intern with FE PF Desk.
Disclaimer: This content is for information purposes only. Mutual Fund investments are subject to market risks. Please consult your financial advisor before investing.