Mutual Funds Day 10: Active versus Passive Funds
Active means there is a direct involvement of labor & Passive means utilizing systematic or computer-generated instructions to do the stock pickings.
“Buy index funds. It might not seem like much action, but it’s the smartest thing to do.” — Charles Schwab
“The miracle of compounding returns is overwhelmed by the tyranny of compounding costs.” — John Bogle
When a fund manager makes the buy/sell decision for a Mutual Fund, there is a cost involved i.e. Salary of the Manager. Active Funds always employs a full-time Manager and many Assistant Managers. Even Active Funds will use Algorithms and Computer-generated instructions to scan & screen good stocks, but a Manager does the final go-ahead.
Passive funds on the other hand are based on preset conditions, logic, systems, or a mathematical model. For example, the Nifty50 Index fund. NSE maintains the Nifty50 index and it tracks a basket of 50 stocks. An AMC could copy the same weights and buy/sell stocks via a computer program. A fund manager is not required in this case hence the AMCs will be able to lower the costs.
There are pros and cons to each method.
- If the stock markets are stable, then passive funds will outperform the active funds due to lower cost structure.
- If the markets are highly volatile, an active should be able to capitalize on opportunities & then provide better returns.
- If the growth in an economy is not uniform, but select pockets or sectors are growing, then active funds will outperform passive ones.
- If the fund manager & team are extremely talented, they would be able to beat the benchmark returns YoY, and hence active funds will perform better.
Mutual funds in itself are passive financial products to most investors. None of my clients does trading on mutual funds, they buy and hold for life. Most of them do not redeem also.
India is a growing economy and it is unlikely that all the sectors will witness growth on the same scale. A sectoral growth or theme may take multiple years to uncover. Due to changes in technology & processes and government reforms — few sectors get outsized benefits. It is always preferred to have 1 or 2 good active funds (sector or theme-based) and also a passive fund to take advantage of the cost structure.
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