Active vs Passive Mutual Funds: Which Should You Choose? (2024)

Last Updated on August 21, 2023 at 6:23 am

A mutual fund is a financial instrument that pools money from the investor and invests on their behalf. As mutual funds become more popular, investors face difficulty making choices.

Mutual funds are segregated into two main categories: active and passive mutual funds. If you invest through a broker, the most likely changes are that they will suggest actively managed funds, leading them to more commission. In this article, I will help you understand the pros and cons of both categories (active vs passive mutual funds) so that you can make an informed decision.

About the author:Salma Sony is a SEBI Registered Investment Adviser and a Certified Financial Planner with 13 years of experience in the financial industry. She is an M.B.A. Finance graduate and has guided 300+ families in comprehensive financial planning with a vision to advise families to achieve financial wellness and peace of mind. She can be contacted via her website:salmasony.com. This is an archive of investment planning articles by Salma.

Salma is a member of Fee-only India, an informal association of flat fee-only financial advisors. Launched in Sep 2017, it helps connect investors with SEBI-registered investment advisors without conflict of interest. Dr M Pattabiramanis a founder-patron of fee-only India.

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What is a Benchmark? Simply put, the benchmark is a reference point that helps investors and fund managers assess the fund’s performance relative to a specific index. Benchmarks are used to measure how well a mutual fund is performing compared to a predefined investment strategy.

In active mutual funds, the fund manager aims to outperform the benchmark, whereas in passive mutual funds, the fund manager seeks to replicate the benchmark performance. Let’s understand them more profoundly.

What are active mutual funds? Active mutual funds are managed by professionals (fund managers) who actively manage the fund’s portfolio to outperform a specific market benchmark.

These funds aim to generate returns that surpass the benchmark by making strategic investment decisions based on research, analysis, and the manager’s expertise.
Here is an example of fund, category & benchmark:

XYZ-1 Equity Fund, Actively Managed – Equity Large Cap Fund, S&P BSE 100 TRI
XYZ-2 Equity Fund, Actively Managed – Equity Flexi Cap Fund, S&P BSE 500 TRI
XYZ-2 Equity Fund, Actively Managed – Equity Mid Cap Fund, S&P BSE 150 Mid Cap TRI

So, in the above example, the fund manager of XYZ-1, XYZ-2 & XYZ-3 equity funds aim to outperform their respective benchmark by making strategic investment decisions based on their research, analysis, and expertise.

How Are Active Mutual Funds Managed?

As the name defines, active mutual funds are managed actively by a team of professionals researching and selecting investments. The managers decide which securities to buy and sell based on their analysis of economic conditions, market trends, company financials, and other relevant factors.

It is important to note that each mutual fund has its objective, and all the fund manager’s decisions align with the fund objective.

What Are Passive Mutual Funds?

Passive mutual funds are also well-known as index funds and are not actively managed. Here the fund manager aims to replicate the benchmark. Passive fund managers buy and hold securities relevant to a benchmark index. Passive funds follow a more systematic and rules-based approach.

How Are Passive Mutual Funds Managed?

The primary goal of passive funds is consistently tracking the benchmark’s performance over time. While slight variations may occur due to factors like tracking error and fund expenses, the aim is to mirror the benchmark’s returns clos

Pros and Cons – Active vs Passive Mutual Funds

Active Funds – Pros and Cons

Pros:

Active funds have the potential for higher returns due to active management and skilful decision-making.
Active funds have the flexibility in portfolio adjustments to grab on market opportunities.

Cons:

Higher management fees and operational expenses (expense ratio).
Higher risk of underperforming the benchmark.
Dependence on the fund manager’s expertise.

Passive Funds – Pros and Cons

Pros:

There are lower management fees and operational expenses (expense ratio) than active funds.
Reduced the risk associated with the fund manager’s decisions.
Reduced dependency on individual manager decisions.

Cons:

Passive funds have no potential for outperformance beyond the market index.

Which Fund Should You Choose – Active vs Passive Mutual Funds?

Here are two critical factors you must consider apart from your financial goals, investment time horizon and risk appetite.

Mindset:If you want to take market risk but have a passive investment mindset, consider investing in an index fund. However, aggressive investors can opt for active funds.
Time commitment and personal involvement:If time commitment concerns monitoring your portfolio, you must consider a passive mutual fund. However, getting expert help for yourfinancial planningcan go with a balanced approach (mix of active & passive funds).

Remember:Index / passive funds are subject to market risk, just that risk associated with fund managers’ decisions is eliminated. So, monitoring your goals is essential even if you opt for passive mutual funds.

Conclusion

The active vs passive mutual funds debate revolves around whether active fund managers can consistently beat the benchmark after accounting for their higher costs.

Passive funds, such as index funds, track a benchmark and aim to match its performance with lower fees. The debate centres on whether the higher fees of active funds are justified by their potential for higher returns.

My view is that choice between active and passive funds is not one-size-fits-all. It’s essential to consider your financial goals, investment time horizon, and risk appetite, then diversify your investments that include active and passive funds personalized to your investment goals and risk tolerance classes to manage risk effectively.

About The Author

Dr. M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter, Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.

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FAQs

Active vs Passive Mutual Funds: Which Should You Choose? ›

For example, when the market is volatile or the economy is weakening, active managers may outperform more often than when it is not. Conversely, when specific securities within the market are moving in unison or equity valuations are more uniform, passive strategies may be the better way to go.

Should I invest in active or passive funds? ›

Passive management generally works best for easily traded, well-known holdings like stocks in large U.S. corporations, says Smetters, because so much is known about those firms that active managers are unlikely to gain any special insight. “You should almost never pay for active management for those things.”

View Details ›

Which mutual fund is best active or passive? ›

Active funds strive for higher returns and come with higher costs and risks. Passive funds offer steady, long-term returns at lower costs but carry market-level risks. Explore key differences between active and passive funds in this blog.

Discover More Details ›

Is active or passive investing riskier? ›

Consistent and low-risk returns — Because of the extreme diversification in most passively traded funds, investors will usually see a consistent return on their investment with generally lower-risk active management.

Which type of fund outperforms most others active or passive? ›

While passive funds still dominate overall due to lower fees, some investors are willing to put up with the higher fees in exchange for the expertise of an active manager to help guide them amid all the volatility or wild market price fluctuations.

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What are the disadvantages of active funds? ›

Cons

there's no guarantee an active fund will perform better than the index – in fact, research shows that relatively few active funds do.
it's not enough to just beat the index – active funds have to beat it by at least enough to cover their expenses, such as transaction fees.

More items...

How often do active funds outperform passive funds? ›

Actively managed funds' recent surge did little to change their long-term track record. Less than one out of every four active strategies survived and beat their average passive counterpart over the ten years through December 2023. One type of active investment strategy generally trails in long-term success rates.

Read On ›

Are active mutual funds worth it? ›

When things go well, actively managed funds can deliver performance that beats the market over time, even after their fees are paid. But investors should keep in mind that there's no guarantee an active fund will be able to deliver index-beating performance, and many don't.

Find Out More ›

Do active funds outperform? ›

In 2022, when the Federal Reserve launched its most aggressive rate-hiking cycle in decades and sent the S&P 500 tumbling, 63.3% of active funds outperformed. In 2014, only 14.2% did. Over the past 10 years, the average share of active funds that beat the S&P 500 was 27%, setting up 2024 to be an especially weak year.

What is the problem with passive investing? ›

The Danger of Passive Investing for Markets

That is, in a market downturn, there may be a rush for the exits as both passive and active investors get out of large cap stocks. This may become even more of an issue as passive funds continue to take market share from active peers.

Which mutual funds consistently beat the S&P 500? ›

That makes outperforming the S&P 500 on a consistent basis no small task. The one fund that has beaten the index in nine of the past 10 years is the Technology Select Sector SPDR Fund (NYSEMKT: XLK).

Get More Info ›

What is one disadvantage of the passive strategy? ›

Disadvantages: Limited Upside: By mirroring the market, passive investments will never outperform the index they track. No Downside Protection: During market downturns, passive strategies do not adjust to mitigate losses.

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Which is better, an active or passive mutual fund? ›

Passive funds tend to have lower expense ratios compared to actively managed funds. This is because they require less research, trading, and management, resulting in lower costs. “Over time, these cost savings can compound and make a significant difference in an investor's total returns,” said Sonam.

View Details ›

Is it better to be an active or passive investor? ›

For example, when the market is volatile or the economy is weakening, active managers may outperform more often than when it is not. Conversely, when specific securities within the market are moving in unison or equity valuations are more uniform, passive strategies may be the better way to go.

See Details ›

Why do some investors prefer passive portfolio management? ›

Owing to less frequent trading, passive portfolio management generates fewer taxable events. This often results in greater tax efficiency and potentially higher after-tax returns for investors. For example, passive portfolios eliminate short-term capital gains (STCG) tax entirely due to their buy-and-hold approach.

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What is better passive or active income? ›

While active income can give stability, passive income builds a safety net that can help you achieve financial independence sooner. Plus, having both types of income could lead to opportunities for further wealth generation, empowering you to live the lifestyle you desire while also saving for the future.

Get More Info Here ›

Are active funds worth it? ›

When all goes well, active investing can deliver better performance over time. But when it doesn't, an active fund's performance can lag that of its benchmark index. Either way, you'll pay more for an active fund than for a passive fund.

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Do active funds perform better in down markets? ›

Using data from 1980-2008, we find that the most active funds outperform the least active ones by 4.5 percent to 6.1 percent per year in down markets after adjusting for risk and expenses. On the other hand, the most active funds do not outperform in the up markets.

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