What are passive funds, how are they different from active funds?

Padmaja Choudhury   /   June 27, 2022
what are passive funds

Read on about the differences between active and passive funds before making any investment decision.

You must know what are passive funds before you do your next investment. Whenever there’s a discussion about the strategies for investing, different people, investors and experts have different views regarding the right choice. And when it comes to mutual funds, some investors believe in active funds while others like to invest in passive funds.

Both the categories of funds have their advantages and disadvantages.

An experienced fund manager manages active mutual funds, and the goal is to beat the market index and take advantage of market fluctuations. However, this is not the case with passive funds. The fund will replicate the underlying index.

If you are confused and want to know what is passive investing, you will get all your doubts cleared after reading this blog.

What are passive funds?

Passive investing refers to the investment strategy involving tracking a market index such as the Nifty 50 and Sensex. If the index makes some alterations or, let us say, replaces a few of the companies involved in it, the passive investor will make similar changes to their portfolio.

However, tracking and investing in 30 or more stocks is not a joke, and most investors don’t have the resources to do so.  

So, passive funds are the simpler and more affordable option for passive investment as the passive fund manager will closely track the index and make the necessary changes to the portfolio.

The main aim of passive funds is to deliver returns similar to the underlying benchmark.

As the constituents of the underlying index don’t change frequently, a passive investment strategy is generally called a Buy & Hold investment strategy.

A passive investment strategy is suitable for new investors as it provides them with enough diversification, limits their risk exposure and rewards them with decent returns at lower costs.

Types of passive funds

Index funds and ETFs are the two types of passive funds.

Index funds

Index funds are mutual funds that track a particular index. It can be a broader market index like NIFTY 50, Sensex etc., and the fund house manages it.

Exchange-traded funds

ETFs are similar to index funds, but the units of the ETF can be traded on the exchange. However, you will need a Demat account to buy and sell ETF units. Also, unlike an index fund with a daily Net Asset Value(NAV), ETFs, in addition to NAV, has a current trading price that allows market participants to buy and sell ETF units throughout the trading session.

Pros and cons of passive investment strategy

A passive investment strategy comes with its own set of pros and cons.

Pros:

Low maintenance: It requires very low maintenance as it does not involve buying and selling securities often. You already know that you’re in the game for the long run, and there are high chances you won’t be bothered by short-term market fluctuations.

No fund manager risk: In an actively managed fund, fund managers may make wrong investment decisions that adversely affect the fund’s returns. However, the passive fund is free from any fund manager’s bias.   

Low fee: Passive funds have a lower expense ratio because the fund managers don’t make any investment decisions.

Transparency: An index fund will not hold investments outside its index. Hence, there is a great level of transparency.

Cons:

Limited choices: If you buy an index fund or an ETF, you can not choose to drop securities even if you don’t want to take exposure to that company.

Lesser returns: The gains from passive investments are not meant to outperform the market. While these funds are supposed to generate returns similar to the index, the returns by these funds are generally lower than the index because of the fund’s expense ratio and allocation to cash, among others.   

Passive investment strategy vs active investment strategy

Here are some of the main differences between passive and active investment strategies:

Investment objective

In an active fund, the manager buys and sells securities to get higher returns than the specific index. It may be an NSE or BSE index.

While in passive investment, the manager aims to replicate the index and earn returns in line with the index.

Expense

In active investing, there are a huge number of transactions involving buying and selling securities, leading to an increase in the expense ratio.

Passive investment strategies do not involve frequent buying and selling transactions; hence, the operating costs are comparatively low.

Involvement of the fund manager

Active investing is more time and effort-consuming as it requires constant technical analysis of stocks, price discrepancies, etc.

Passive investing is less time-consuming as the manager doesn’t have to research and analyse stocks extensively.

Final words: Which one should you pick?

Passive funds are mutual funds that depend on the index, and passive fund managers don’t make investment decisions.

It tracks the market without employing any active strategies. Active funds are managed by fund managers who apply techniques to generate alpha.

It is a debatable question which investment strategy you should pick. There is no strategy right or wrong, and there’s nothing one size fits all when it comes to making investment decisions. It all depends on what fits your investment goals and risk tolerance. A combination of these two can also be an excellent option for many investors.


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