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In active funds, fund managers select stocks with an aim to beat market returns, whereas in passive funds, they pick stocks to replicate a benchmark index’s return. Typically available at higher expense ratios, active funds rely on research and analysis to outperform market returns, whereas passive funds simply mirror an index and are characterized by lower risk and costs.
Which of the two types of funds is riskier, and which could be more suitable for long-term wealth creation?
In this special series, titled ‘Seekho Paiso Ki Bhasha’ (Learn the Language of Money), Kotak Mutual Fund MD Nilesh Shah simplifies complex market concepts in a candid and accessible way.
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“Fund managers charge a higher fee in active funds than in passive funds. But they ensure good financial health, just like doctors ensure good physical health,” says the veteran fund manager.
“You pay a higher fee for a better service in active funds, as simple as that,” he adds.
Index Funds & ETFs vs Active Funds | Which works better?
Passive funds are usually available at relative lower costs compared to active schemes. In other words, they come with relatively lower expense ratios, meaning investors pay a smaller percentage of their assets to cover operating costs such as management fees and administrative expenses. Essentially, this is the portion deducted from returns to account for fund management costs.
“In active schemes, the fund manager charges a higher fee while attempting to beat benchmark returns. This higher fee reflects the market-beating alpha generated in the schemes,” says Shah.
How do fund managers pick stocks in active schemes?
“A stock enters and exits an index for several reasons. For instance, in a 500-scrip index, a stock is generally included when it beats at least 300 stocks… Simply put, a stock outperforms a certain number of stocks before making an entry into such an index. On the other hand, the stock has to underperform 800 scrips before exiting,” explains Mr. Shah.
“Fund managers always try to buy index-beating stocks, buying them before their performance improves and selling before it deteriorates. Successful stock identification is key to market-beating returns. This is missing in passive funds,” he elaborates.
‘A horse for long-distance race always wins in a dynamic market’
Active fund managers always focus on market-beating stocks, which is contrary to passive investing, where the purpose is to mirror index returns.
“In a rising market, both horses and donkeys run alike. In our market, at times you see donkeys outpacing horses… Think of it this way: Speculators often bet on donkeys, but fund managers always place their money on horses. But eventually, a long-distance racing horse always wins,” he says.
This is exactly where an active fund’s manager proves their worth, Shah emphasises.
In which situations do active funds work better than passive funds?
Active funds always work better in fundamentals-driven market moves than broad-based ones, concludes Shah.
“In the absence of momentum- or liquidity-driven markets, a good fund manager will always have better chances of beating market returns in active schemes,” he adds.
The ‘Seekho Paiso Ki Bhasha’ series aims to break down investment concepts into simple, relatable terms.
An investor education and awareness initiative by Kotak Mahindra Mutual Fund.
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