If you are new to the jargon, an actively managed fund is the one where the fund manager takes call based on research and analysis on what should the portfolio be, how much and when. The fund managers call the shots based on several parameters that they have outlined as a part of the investing process.
In contrast, a passively managed fund does not need a fund manager. Not literally. Someone does need to take care of the investor’s money. The difference lies in the fact that an index fund simply invests its money in a pre-identified portfolio of stocks. This pre-identified portfolio is usually a popular market index.
I am sure you have heard of Sensex, Nifty, etc. They are popular stock market indices. Sensex for example is a bundle of 30 large stocks that are listed on the Bombay Stock Exchange (BSE). Nifty is a collection of 50 such stocks that are listed on the National Stock Exchange (NSE).
The 30 of the Sensex or the 50 of the Nifty also have predetermined weightage for each of the stocks. These allocations change over time as markets grow, companies grow – that’s a different story though.
A passive index fund has a simple job.
Just take a look at what are the stocks and their respective proportion in the market index. Invest the money in exactly the same stocks and in exactly the same proportion.
After that it has to ensure that the stocks and the proportion remain in tandem with the index. If the proportions change – the fund manager shuffles the portfolio to reflect the new ones. That’s it.
Unlike active fund management, there is no research involved and no extra effort in figuring out which stocks to buy, at what price and when.
Suppose we launch Unovest Index fund – Sensex Plan. We have to simply look at the 30 stocks of the BSE Sensex and invest the money in the same allocation as in the index. Wow! I got a ready-made portfolio.
Hope you get the reason it is called passive fund.
The success of the index fund is measured in how close it is able to replicate the performance of the underlying index it is copying. There is a little difference that does show up and that is called a tracking error. The lower the tracking error, the better the fund is.
An example of a passive fund or index fund is Franklin India Index Fund – Sensex Plan. This fund aims to replicate the returns of the BSE Sensex by investing in the same stocks as in the Sensex and in the same ratio.
On the other hand, the active fund‘s job is a tough one. It has to beat the underlying benchmark returns. After all that is what you pay for and hence expect, right?
Take for example, Franklin India Bluechip Fund. The fund benchmarks itself against the BSE Sensex. The fund will work to deliver a performance better than the BSE Sensex. Hence, it will carry out necessary research and analysis, create investment strategies and decide which stocks and companies make the best investment opportunities.
Active fund or passive fund
If you expect a fund manager to invest your money and deliver a superior performance, go for an active fund. Else, you are just better off investing in an index fund.
Remember an active fund charges additional expenses. The expenses are higher than a passive fund. In our above examples, Franklin Sensex Plan (Direct) has an expense ratio of 0.85% vs 1.32% of Franklin India Bluechip Fund.
In the Indian context, passive funds have not done very well. It is partially blamed on the wrong construction of indices.
Having said that anyone looking to take exposure to equities at a low cost without depending upon the whims of individual investment style, an index fund is a great investment option.