Part 12 Explained How to Trade Active and Passive Funds
In Short Understand Active and Passive Fund Investments
Part 12 Explained How to Trade Active and Passive Funds
Active Funds in India -
Definition:
Actively managed funds in India involve fund managers or teams who actively select securities (stocks, bonds, etc.) to outperform a benchmark index, such as the Nifty 50, Sensex, or sectoral indices.
They rely on research, market analysis, and expertise to make investment decisions.
Management:
Fund managers actively monitor markets, assess economic conditions, and adjust portfolios through stock picking, sector rotation, or market timing to generate alpha (excess returns over the benchmark).
For example, a large-cap equity fund manager might choose specific stocks to outperform the Nifty 50.
Objective:
The primary goal is to beat the benchmark index, delivering higher returns than the market average.
Costs:
Expense Ratios:
Higher, typically ranging from 1% to 2% (Total Expense Ratio, or TER) due to active management, research, and frequent trading. SEBI regulates the maximum TER for active funds.
Transaction Costs:
Frequent buying and selling lead to higher brokerage and tax implications.
Risk/Return:
Higher Risk:
Active funds carry risks tied to manager decisions, which may lead to underperformance if stock picks or market timing fail.
Potential for Alpha:
In inefficient market segments like small- and mid-cap stocks, active managers can exploit opportunities to generate significant outperformance.
For instance, small-cap funds have shown 100% outperformance in some periods.
Performance Variability:
While some active funds outperform (e.g., top alpha creators in large- and mid-cap categories), many fail to consistently beat benchmarks after fees.
An ET Wealth study noted that small-cap funds often outperform, but large-cap active funds struggle.
Examples:
Equity mutual funds, debt mutual funds, hybrid funds, or fund-of-funds managed by firms like HDFC Mutual Fund, ICICI Prudential
Popularity:
Active funds are more popular in India due to the belief that skilled managers can navigate market inefficiencies, especially in small- and mid-cap segments.
They are seen as tools for long-term goals like wealth creation for education or retirement.
Advantages:
Flexibility:
Managers can pivot in or out of stocks during market upheavals, potentially avoiding losses (e.g., avoiding overvalued tech stocks during the 2000-2001 dot-com bust).
Potential for High Returns:
In less efficient markets like small-caps, active management can deliver substantial alpha.
Disadvantages:
Higher Costs:
High TERs and transaction costs reduce net returns.
Manager Risk:
Performance depends on the manager’s skill, and high-performing managers may leave, impacting fund performance.
Inconsistent Performance:
S&P Dow Jones Indices’ scorecards show many active funds in India underperform their benchmarks over long periods.
Key Features:
Goal:
Beat the market (e.g., outperform Nifty 50 or Sensex)
Management:
Actively managed
Cost (Expense Ratio):
Higher (1%–2.5%) due to management fees
Risk:
Higher (due to fund manager's decisions)
Returns:
Can be higher or lower than benchmark
Examples:
Axis Bluechip Fund, HDFC Top 100, etc.
Pros:
Potential for higher returns
Professional expertise to handle market volatility
Cons:
Higher fees
Performance depends on fund manager’s skill
Passive Funds in India -
Definition:
Passive funds aim to replicate the performance of a specific market index, such as the Nifty 50, Sensex, or Nifty Total Market Index, by holding the same securities in similar proportions.
They involve minimal active decision-making.
Management:
Fund managers follow a predetermined set of rules to mirror the index, with adjustments only when the index composition changes.
No active stock selection or market timing is involved.
Objective:
To match the benchmark’s performance, providing investors with market-linked returns minus fees.
Costs:
Expense Ratios: Lower, typically 0.03% to 0.5% for index funds and up to 1% for ETFs, as per SEBI regulations.
For example, the SBI ETF Nifty 50 has an expense ratio of 0.07%.
Transaction Costs:
Minimal due to a buy-and-hold strategy, reducing trading activity.
Risk/Return:
Lower Risk: Less risk from manager error, as the fund tracks the index.
However, they are fully exposed to market volatility.
Market-Matched Returns:
Returns closely mirror the index (e.g., Nifty 50 or Sensex), with minor deviations due to tracking errors or fees. Passive funds rarely outperform but are consistent.
Tracking Error:
The difference between the fund’s and index’s returns can occur due to fees or imperfect replication. Investors should choose funds with low tracking errors.
Examples:
Index funds like the HDFC Sensex ETF, SBI ETF Nifty 50, or Bharat Bond ETFs, and thematic funds tracking indices like the Nifty Tourism Index.
Popularity:
Historically less popular than active funds, but passive funds are gaining traction in India.
Assets under management (AUM) for passive funds grew 4x from January 2019 to February 2022, with significant growth in equity (100x) and debt (39x) ETFs.
In 2024, 63 new passive fund offerings were launched compared to 51 in 2023.
Advantages:
Cost-Effectiveness:
Lower fees maximize net returns. For example, the HDFC Sensex ETF has a TER of 0.05%.
Broad Market Exposure:
Funds like those tracking the Nifty Total Market Index (750 stocks) offer diversification across sectors.
Simplicity:
No need to monitor manager performance or worry about fund manager changes, making them ideal for hands-off investors.
Liquidity:
ETFs, traded on exchanges like NSE or BSE, offer high liquidity, though some ETFs may have lower trading volumes.
Key Features:
Goal:
Match the market (index returns)
Management:
Passively managed
Cost (Expense Ratio):
Very low (0.1%–0.5%)
Risk:
Lower than active funds (no manager bias)
Returns:
Same as the index (before expenses)
Examples:
Nifty 50 Index Fund, Sensex ETF
Pros:
Very low cost
Transparent and predictable performance
Which One Should You Choose?
Choose Active Fund if:
You believe in the fund manager’s skill.
You're okay with higher fees for potentially higher returns.
Example Use Case:
An investor aiming for wealth creation over 10+ years might choose an active small-cap fund to capitalize on India’s growth potential.
Choose Passive Fund if:
You want low-cost, predictable market returns.
You prefer a hands-off, simple investment approach.
Example Use Case: An investor seeking diversified exposure to the Indian market might choose an ETF like the SBI ETF Nifty 50 for low-cost, market-aligned returns.
Hybrid Approach:
Many experts suggest combining both. Use passive funds for large-cap exposure (e.g., Nifty 50 ETF) and active funds for small- or mid-cap segments to balance cost and alpha potential.
In short -
Let’s explore how buying and selling (buy/sell mechanism) works in Active vs Passive Funds, including the experience from an investor’s point of view in India:
Active Funds -
Buying Active Funds
You buy at the Net Asset Value (NAV) published at the end of the trading day.
No intra-day buying or selling.
Ideal for long-term investors.
Example:
If you place an order before 3 PM, you get same-day NAV.
After 3 PM → next day’s NAV.
2. Selling Active Funds
Again, sale happens at day-end NAV.
Funds are usually credited back in 1–2 working days.
May incur exit load if sold early (within 1 year in many equity funds).
Passive Funds Buying and Selling -
Buying Passive Funds
Index Fund (Mutual Fund Format):
Same as active fund — buy/sell at NAV.
Long-term investment style.
ETF (Exchange-Traded Fund):
Traded like stocks on NSE/BSE.
You can buy/sell anytime during market hours.
Prices fluctuate in real-time like shares.
Needs a demat account (not needed for regular mutual funds).
4. Selling Passive Funds
Index Fund:
Like any mutual fund — sell to AMC.
Day-end NAV applies.
ETF:
Sell on stock exchange.
Quick and easy like stock.
T+1 or same-day credit depending on your broker.
Conclusion
If you want a simple, long-term SIP approach:
Choose Active Fund or Index Fund (no demat needed).
If you want to trade passively like stocks with instant buying/selling:
Choose an ETF (needs demat account).
