If you’re just getting into the world of investing, it can be a daunting task to navigate your way through the many options available. We’ve prepared a quick primer for beginners to explain the key differences in the two major ways of investing, active portfolio management v/s passive portfolio management.
What is Active Portfolio Management?
As the term suggests, when investors engage the help of fund managers or wealth managers to beat the benchmark index it is called active management. In simple terms, it involves a strategy that aims to maximize returns by beating the market and assets are actively traded at a higher frequency. There’s a lot more action and risk in an active portfolio versus a passive one.
Active funds are managed by experts who keep juggling your money based on the opportunities in the market. There’s a lot of in-depth research and forecasting that goes into the process and hence the team charges a fee for their services. An active fund may give you access to a portfolio management platform and portfolio analytics so that you can get a birds-eye view of what’s happening in your portfolio. The fund managers take into consideration a large number of factors such as politics, economics, global cues and market movement to gauge the right strategy to invest your money. The fees charged by the fund manager in an actively managed portfolio is called the expense ratio of the fund which is a certain percentage of your assets being managed.
What is Passive Portfolio Management?
Passive portfolio management is also known as an Index fund management is a type of fund where the objective is to make the same returns as the index it is benchmarked against. For example, if the Sensex gains 100 points in a year, the fund is designed to mimic the same performance.
Since the idea is to replicate the index, there is no need for a dedicated team of experts to monitor the funds actively. Once the effort is made to purchase the securities, the portfolio will follow the fluctuations of the market and mimic it. There’s no additional juggling or effort on behalf of the fund manager.
As a result of the lower efforts on behalf of the fund managers, there’s little or no fee associated with it. Since these funds replicate the market movements, they are preferred as a low-risk investment and are recommended for conservative investors. These funds fall into 3 categories, unit investment trusts, mutual funds, and exchange-traded funds.
Which is better Active or Passive?
Active Management:
Advantages
- Since the funds are actively managed by expert investors, there’s a higher chance of generating a market-beating return.
- They come with great tax benefits as underperforming funds can be sold off quickly.
- Since the funds are monitored regularly, any opportunities can be leveraged in real-time.
Disadvantages
- There’s a higher risk associated as the frequency of market juggling is higher.
- Since they require more effort, the expense ratio is higher and is borne by the investor.
- Off late, active funds have been disappointing in terms of returns when compared to index funds.
Passive Management:
Advantages
- Long term approach and does not require active monitoring by an investor or fund manager.
- There’s higher transparency as it mimics the market movement, there are no surprises.
- Lower risk and better for small investors as minimal fees are paid to fund managers.
Disadvantages
- Limited options when it comes to investing.
- No market-beating returns, no high alpha generated.
What is Right for You?
Based on Expectations
If you want high returns over a short or medium term, you can opt for an actively managed fund. However, if you are willing to be patient and are satisfied with risk-free long term returns that match the market, passive funds are best.
Based on Risk Appetite
If you want a high return on your investment and don’t mind a higher risk exposure then an active portfolio is the right bet. However, if you prefer a diversified fund that is lower in terms of concentrated risk exposure then passive funds are a better option.
