When you commence the mutual fund investment journey, the two main types you will come across are active mutual funds and passive mutual funds in no time. Both of them have the same objective, i.e. to grow your money but in very different ways. Being conversant with these differences will result in better decision-making on where to put your money to maximize it.

Compare it to driving a car:

• Active funds are like a driver who is always changing from one lane to the other in a bid to avoid traffic.
• The passive funds represent the driver who takes a path and holds it through following the general traffic movement.

Which of the two strategies is more efficient? Let’s go into the details and find out.

What Are Active Mutual Funds?

Professionals such as fund managers manage active mutual funds. These managers actively pick stocks, bonds, or other assets to outperform the market. They rely on research, market trends, and their expertise to make decisions.

For example:

• In case the manager believes that tech stocks will perform well, then they will heavily invest in companies like Apple or Microsoft.
• The aim is to outdo the market index, say the S&P 500 or Nifty 50.

While this technique is much more complex and will frequently become costly, it entails certain skills.

What Are Passive Mutual Funds?

Passive mutual funds, a.k.a., index funds, are trying to mimic the performance of an agreed index without any reference to market-beating. Their main goal is simply to shadow it. This implies less work and, therefore, lower maintenance fees.

For instance:

• A passive fund that follows the Nifty 50 is only out there to invest in the same 50 companies in the same proportions as the index.
• The whole concept is to meet the market’s results, not to beat them.

Hence, these mutual funds of passive funds are a well-liked and preferable form of investment for long-term, low-cost.

Key Differences Between Active and Passive Mutual Funds

Aspect	Active Mutual Funds	Passive Mutual Funds
Management Style	Actively managed by professionals	Passively tracks a market index
Goal	Outperform the market	Match the market’s performance
Costs	Higher expense ratios	Lower expense ratios
Risk	Higher risk due to active decisions	Lower risk as it follows the index
Performance	Can outperform or underperform the market	Matches market performance

Human judgment is involved in the decisions of active funds, whereas, algorithms and market trends are in use for the passive ones. This fundamental divergence is reflected in the areas of cost and performance.

Performance Comparison: Active vs Passive Funds

In the past, passive funds have usually been able to outperform active ones in the long run. It is based on research that most of the time active fund managers almost cannot surpass the benchmark indices. It is somewhat related to the higher costs and the obstacles of predicting market shocks.

Although, there is an exception to active funds:

• In some situations where there are recessions, active funds may be running more effectively.
• In contrast, the managers can change according to the market circumstances.

Nonetheless, for the majority of investors, passive funds are a safer and cheaper alternative.

Costs and Fees: Active vs Passive Funds

One of the main distinctions between an active fund and a passive fund is the cost. Active funds take a larger expense ratio ranging in most cases from 1% to 2% of their portfolio. This charge includes expenses related to finding new ideas, research, and the fund manager’s salary.

Unlike these passive funds which do not spend a lot on management, the expense ratios of the passives are usually below 0.5%. The reason for this deficit is that less management is required. Lower fees will make your profits grow faster.

For example:

• If you invest ₹1 lakh in a passive fund with a 0.2% fee versus an active fund with a 1.5% fee, the difference in the returns will be a big number over 20 years.

Risk Factors: Active vs Passive Funds

Active funds are the ones that entail relative risk when the fund manager mainly depends on his own decisions about what to do with the funds. Consequently, a fund may perform worse than expected if the manager decides unwisely. Furthermore, more dynamic funds are often associated with a higher tax burden since they raise their profits through their higher turnover rates.

On the other hand, passive funds have fewer risks as they are bound by the performance of a market index. Although they are still subjected to the ups and downs of the market, they do not carry the risk of a wrong judgement of an individual. As a result, these types of assets are a perfect fit for those who want to keep their money safe but also generate a few returns on their investment.

When to Choose Active Mutual Funds

Active mutual funds might be your best bet if you hope to make a higher return and are at ease with the higher risk. These are the types of funds that suit investors who believe in the savvy of the fund managers and want to exploit the market opportunities.

For example:

• If you are investing in a niche, for instance, healthcare or technology, an active fund would be a preferable choice.
• Such activities often require specialists to find out about the best-performing companies.

Portals such as the ones provided by Zerodha and Upstox can give tools to enable this kind of comparison between funds and how they perform actively.

When to Choose Passive Mutual Funds

At first sight, passive funds are the best for people who plan to invest for the long term and would rather not change their plan once it is set. They are low-cost but belong to those who want low-risk and would like to buy market-risk-free investment assets without worrying about market timing.

If you are about to engage in investing or have no time to check your portfolio all the time, passive funds are the best ones. Applications like Paytm Money and Alice Blue are the perfect tools to start in index funds without experiencing so many technical difficulties.

How to Compare Mutual Funds: Tools and Tips

When they are choosing mutual funds, investors cannot afford to be ignorant of the importance of comparing the funds. Use tools like a mutual fund comparison tool or a fund comparison tool to evaluate performance, fees, and risk. Look at historical returns, expense ratios, and the fund’s track record.

For example:

• If you’re comparing two funds, check how they performed during market downturns.
• Was the active fund able to outstrip the index, or was it left behind?

Tools such as Zerodha or Upstox can assist you in considering these questions using its mutual fund section.

Conclusion: Which One Should You Choose?

Choosing between active or passive mutual funds is a matter of your investment objectives, risk tolerance, and investment time that you determine. If you are sure about the fund manager’s competency and are willing to pay higher fees to potentially obtain greater returns, then active funds are the option for you. On the other hand, if you want to have a less costly and more controllable asset and if possible, obtain performance at least equal to that of the market, then the answer is passive funds.

However, needless to say, the answer does not always apply to everyone. Moreover, it can even be seen as smarter by the investors that invest in equal amounts of both types. For further tips, you can refer to our article on How to Build a Portfolio with Mutual Funds

FAQs

What is the key difference between active and passive mutual funds? 

Active funds are those that professional managers monitor to ensure that the returns obtained are higher than those that are generated in the market, while passive funds are the ones that achieve their objectives by purchasing securities that are the same as the index.

Which type of fund has lower fees? 

In general, passive funds are the ones that have a lower fee ratio compared to active ones.

Can active funds consistently beat the market? 

The large majority of the active funds fail to consistently attain the result that their respective benchmark indices have obtained, especially when looking at the long term.

Are passive funds risk-free?

The answer is No, passive funds are still subject to market risk. However, they reduce the risk of bad decision-making taken by the fund managers by avoiding them.

How do I choose between active and passive funds? 

You have to think your risk tolerance, your investment goals, and your time horizon through. You use tools like Zerodha, Upstox, and Paytm Money to compare the funds and to have a better portfolio.