Active vs Passive (Index) mutual funds? Which one is better for you?

Active vs Passive mutual funds? Which one is better for you? | Vrid
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In our previous blog, we discussed the categories of equity and debt mutual funds based on their market capitalisation and maturity period.

In this blog, we will discuss the types of mutual funds based on their management style. We will look at how different management styles can affect the risk and returns of mutual funds.

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In an earlier post, we covered why you should always pick direct mutual funds over regular mutual funds. There, we discussed how picking direct plans over regular plans generated more returns as there was no middleman involved in collecting a commission from the mutual fund house. 

Direct and regular mutual funds discussion speaks more about the sales part of the mutual fund. But what about the creation part? The day-to-day management of the fund?

As we explained earlier in that post that a manager manages your money and invests in equity and debt for you. In the financial world, there are two types of management: active and passive. 

And in the stock market, we have built some index based on the market capitalisation of the listed companies (discussed here). These indexes help us understand how the market is performing. You would have heard about Nifty 50 or Sensex 30, right?

These are indexes, where the Nifty 50 comprises the top 50 listed companies in India, based on market capitalisation. Sensex has the top 30 companies. And similarly, we have Nifty Next 50, Nifty 100, Nifty 200, etc. We also have other indexes that focus on particular sectors like Finance, Pharma, IT, etc. 

SEBI, the market regulator of India, has made it a rule that every mutual fund should clearly define its investment style, and management style and benchmark itself against an index. 

Benchmarking their fund against an index helps us to compare how well the mutual fund has performed against the index and among other mutual funds.

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How is the management style of a fund manager linked to these indexes? Let’s discuss. 

Active Management in mutual funds

Under the active management style, the manager says he will use his expertise to pick the stock to buy or sell based on the market conditions. 

So if the fund invests in Nifty 50 companies, the manager can buy or sell any company at any time, and the proportion of his fund allocation can vary too. Some managers invest more in IT and some more in Finance.

If a manager wants to follow an active management style, he needs to be up to date with everything in the market. So he has a big team of analysts to do the research work. And all this comes with a cost. 

Therefore, the manager charges you extra as an expense ratio. And in return, you can ask the manager to generate better returns than the benchmark index. This seems fair since you are paying him extra. 

In market terms, it is called alpha, when a fund generates better returns than a benchmark index. For example, if nifty 50 gave a return of CAGR of 12% in the last 5 years, and an active fund generated a return of 15% in the same period, then the active fund is said to have achieved an alpha of 3%.

But are the active managers able to generate enough alpha to justify their extra management fees? Will discuss this in some time.

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Passive Management in mutual funds

Under passive management, the manager says he will just copy the index. He won’t make any active decisions. For example, if the fund manager benchmarks the fund against the Nifty 50, the fund will replicate the Nifty 50 investments. That is why funds managed with a passive management style are also called index funds. 

Now to copy an index shouldn’t require much work, right? So they don’t have a big team. Thus, their expense is less, and they charge you less than the active managers to manage your money. 

Since they are just copying the index, they should be able to generate similar returns as the index, and we should expect them to achieve more. 

How do you feel about this? Are you thinking, why would anyone invest in passive or index funds where they are just copying the benchmark index? You will invest in active funds where you can generate better returns than an index. 

But here raises the question of whether the active funds could generate enough alpha to justify their higher expense ratio.

Which mutual fund management is better?

We looked into the historical performance of active and passive funds to save you some time. The answer to whether the active funds are better than passive/index funds is Yes and No.

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Yes, because the active funds were able to outperform the index in small-cap and mid-cap mutual fund schemes.

No, because the active funds mostly failed to outperform the index in large-cap mutual fund schemes. 

So if you are looking to invest in Nifty 50, Nifty next 50, Sensex 30 and Nifty 100 companies, it is better to invest in the index or passive funds. The reason being the stock market is more mature in the top 100 companies segment. So it is hard for active funds to outperform an index consistently in the long term. 

If you are hoping to invest in small and mid-cap companies, you might look for active funds. As some funds were able to use the market inefficiencies, their expertise and other factors to outperform the index in the long term. 

Remember to buy only a direct plan while investing in mutual funds. And if you are interested in looking into the historical performance of active and passive funds and other research points, check the still curious section below. 

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Still Curious?

If you are like us, who likes to analyse a little more or check out content in different formats, well you are in luck. Below you can find some suitable content we found.

SPIVA – SPIVA Scorecard – India

The Economic Times – Are active equity mutual funds actually underperforming the passive funds?

ET Money – Which is Better – Index Funds VS Actively Managed Funds | History, Advantages, Performance and Risk

Note: We don’t have any affiliation with them. We are sharing links only for educational purposes. The opinions expressed by them belong solely to them and do not reflect the views of Vrid.

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DISCLAIMER: This newsletter is strictly educational and is not an investment advice or a proposal to buy or sell any assets. Please be careful and do your own research.

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