You must have heard of passive mutual funds. They are low-cost, as well as simple. But the main question, is being low-cost enough? Or are passive funds also better performing than active funds? The data shows a slightly different picture. So in this post, we will compare through data whether active funds are better or passive funds.
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| Active Fund vs Passive Fund |
First, let's broadly understand how passive funds work
Index funds or passive mutual funds are funds that follow the performance of a market index like Nifty 50, the Sensex 30, the Nifty 500 follow their performance. Its goal is not to beat the index, but to provide returns similar to it. In this fund, the fund manager doesn't actively select stocks. The fund holds the index's stocks in the same pattern. For example, if we look at a Nifty 50 index fund, then that fund will invest in the companies of the Nifty 50 index, exactly the same in terms of weightage. For instance, if Reliance's weightage in Nifty 50 is 8%, then it will be 8% in the fund as well. Similarly, all the other stocks will be within the same percentage in that fund as well. Passive funds are usually low-cost because they don't require active research and frequent stock selection.
How active funds work
On the other hand, if we talk about active mutual funds, in an active mutual fund, a fund manager actively decides which shares or bonds to buy or sell. Its goal is to than market indices like the Nifty 50. The fund manager's research and decisions become important. That's why fees are usually higher than for passive or index funds. Now, if we talk about some data, then as of now, the adoption of passive investing in India is sharply increasing. According to AMFI data, in May 2021, there were around 8.57 million folios in passive style categories, which increased to 56.6 million folios by May 2026. That's a growth of almost 6.6 times. Whereas during the same period, active folios grew only 2.7 times. This shows that passive strategies have been adopted much faster. However, when we analyzed data from the past few years, surprisingly, some practical problems were also observed in passive funds. And due to these problems, returns within passive funds get dragged down. So, we will analyze three points related to active and passive funds. Based on that, you can decide whether to invest in a passive fund or an active fund.
The first point: Market Risk.
When we talk about passive funds, one of the major risks, market risk, is not well covered by passive funds. For example, passive funds do not avoid market crashes. Broadly, if the index falls, the funds fall by a similar amount. For instance, if we take the 2008 financial crisis, where the Nifty 50 corrected by 60% from its peak. So if we had invested ₹1 lakh in a Nifty 50 passive fund, after a 60% correction, our investment value would have remained ₹40,000. If the index corrects by 60%, our fund will also see a correction of at least 60%. It could even be more. Now, why that happens, we will discuss in an upcoming point. We will talk about why that happens in the upcoming points. On the other hand, if we talk about active funds, they are not risk-free. However, a fund manager can protect downside risk by making allocations different from the index. For example, from March 29th, 2019, to March 31st, 2020, if we look at Nifty 500 TRI, which is the Total Return Index, it fell by 26%. On the other hand, if we look at the top three Flexi-cap funds, they fell by an average of 19%. Now, you see, we are comparing Nifty 500 because it is the right index for Flexi-cap funds. So, Flexi-cap funds have the flexibility to shift allocations. Because this is not an index fund, it can be defensive during a crash by holding more weight in sectors like pharma, consumer, non-consumer durables, FMCG. Because of this, these funds decreased significantly less than Nifty 500. Significantly decreased.
Now, if we look at the Second Point: It's Concentration Risk
If we talk about passive funds, passive funds are diversified but if we look at index weightage, often some sectors and stocks become highly concentrated. In the last few years, if we talk about IT in Nifty 50, the IT index weightage has been around 10%. But the problem is that the IT index has given almost 0% returns in the past 3 years, which reduces the returns of any Nifty 50 index. Now, on the other hand, if we look at active funds, it's not that concentration cannot be high there either. But the fund manager is not forced to blindly follow index weights. For example, the current top five performing active large-cap funds' average IT sector weightage, if you look at it, is only 5%, which shows how. Active management can beat passive funds by underweighting an underperforming sector.
That's the Third Point: Tracking Error Risk
Now, if you look at the data for passive funds, you'll see that not a single passive fund has beaten any index. That means 0% of passive funds have beaten any index, not even their parallel indices. The job of passive funds is simply to replicate the index. But generally, they generate lower returns than their benchmark by design. And the reason for this is tracking error, which is the gap between the index and the fund's actual returns. Let's understand this in a bit more detail. See, every passive fund follows its index. Now, an index has no costs, but a passive fund does. For example, there's an expense ratio, and the fund manager running it will incur some costs. There are costs involved. When we rebalance funds, costs are incurred at that time. Also, a portion of every fund is always held in cash, on which we don't earn any returns. The difference that arises from all of this compared to the index is what we call Tracking Error. This cannot be avoided by design. Due to this tracking error, the investor's real return in passive funds is always slightly lower than the index return.
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Are Passive Funds Useless
So, broadly, we can say that active funds generate better returns than the market or can generate better returns than passive funds. But have passive funds become useless in this pursuit? No, we are absolutely not saying that. If you are investing in passive funds, you should be clear. We need to keep in mind that our target is not to beat the index. It's not to generate better returns than the market. If we want to generate better returns than the market, we'll have to go for active funds. Now I'm sure you'll get clarity related to active funds and passive funds from this post.
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