A comparative analysis of active and passive investment strategies in mutual funds

Authored by Raghvendra Nath, Managing Director, Ladderup Wealth Management Pvt Ltd

The Indian mutual fund industry is a fast-growing one, propelled by increased awareness on the part of investors and the horde of variants available for investment. According to the Association of Mutual Funds in India or AMFI, the total assets under management, of the Indian mutual fund industry, stood at Rs 39.6 trillion, as on January 31 2023, indicating a five-fold rise in a mere ten years. A pooled investment vehicle helmed by professional experts, the mutual fund industry is the option of choice for investors keen on participating in the growth of the Indian and global economy, without needing to track the market or take personal trading calls.  

Major Mutual Fund Investment Strategies  

Investment is a very personal sphere, given the fact that individual investors come with their profiles. People choose their preferred mutual fund schemes based on aspects such as their risk appetite, return requirements, time horizon and investment goals and, accordingly, mutual funds offer a host of choices to their investors. One of the biggest factors investors consider, while picking the mutual fund scheme best suited to their unique requirements, is the underlying investment strategy practised by the scheme and this can be either active or passive.   

As the name suggests, active and passive investment strategies are two distinct approaches used by mutual fund managers to generate returns for their investors. Active mutual funds are managed by portfolio managers who use their expertise to select investments to outperform the market. Passive mutual funds, on the other hand, seek to replicate the performance of a market index, such as the S&P 500, by investing in a portfolio of stocks that closely mirrors the index. 

Let us consider examples to understand both of these unique strategies. If an investor is bullish on the pharmaceuticals sector, then they can choose to invest in either a pharma-focused active fund or a passive one. In the active pharma scheme, the fund manager would consistently track the pharmaceutical industry and invest in companies which are expected to outperform the others in the sector. 

Accordingly, if market cues suggest that Sun Pharma will end up performing better than Cipla, over the next couple of years, then the fund manager would increase exposure to the stocks of the former while reducing exposure to the latter. Here, the decision-making power lies in the hands of the fund manager, who takes trading calls depending on their expertise and knowledge of the market, in an attempt to offer returns higher than the one generated by the larger market.  

Alternatively, if the investor picks a passive pharma fund, which tracks the NIFTY Pharma index, then the fund manager will not play an active role in the day-to-day investment calls. Rather, the fund will track the underlying index, and invest its corpus across the different companies making up the index, in the proportion depicted by the index. Therefore, if Sun Pharma makes up 20 per cent of the NIFTY Pharma index, then the same number would be replicated in the passive fund’s composition. The fund manager will not take trading calls, depending on the market scenario – they will follow the index to the T, ensuring that the passive fund offers returns in line with the growth of the overall pharma sector.      

Comparative Analysis of the Strategies 

There are pros and cons to both active and passive investment strategies, and investors should consider their investment goals and risk tolerance before choosing one or the other. 

Active investment strategies aim to outperform the market by selecting individual stocks or other investments that are expected to perform well. Active mutual fund managers use a variety of techniques to identify undervalued securities or those with growth potentials, such as fundamental analysis, technical analysis, and market trends analysis. Active management can be more expensive than passive management, as it requires more research, analysis, and trading activity. They may also be less diversified than passive funds since the fund manager has the option to invest a majority of the corpus in the stock, they consider most lucrative, leaving less space for diversification. 

On the other hand, passive investment strategies seek to replicate the performance of a market index, such as the Nifty50, by investing in a portfolio of stocks that closely mirrors the index. Passive mutual funds are typically less expensive than active funds, as they require less research and trading activity. However, passive funds may not offer the potential for outperformance that active funds do. Separately, passive funds have long been considered an excellent mode of diversification, across sectors and market capitalisation, since they invest in all the stocks listed on the underlying index. This enables such funds to benefit from the gains made by all the stocks on the index, while also reducing the risk when a stock tends to underperform. 

Considering the Optimal Choice 

Most risk-averse investors, who are keen on diversification and low expense ratios, pick passive funds since the market has, historically, proven its capability to offer stable returns, especially in the longer term. However, aggressive investors in the quest for high returns are known to go with active funds, in an attempt to avail market-beating returns, despite the higher expense ratio involved. 

Indeed, there is no clear winner between active and passive investment strategies, as the best approach depends on the investor's goals and risk tolerance. Active strategies may be more appropriate for investors who are willing to take on higher risks for the potential of higher returns, while passive strategies may be more appropriate for investors who prioritize lower costs and long-term, steady returns. 

As an investor, when you choose mutual funds, you pick the passive route since you are not tracking the market or undertaking trading calls. However, despite the passive nature of your investment, you still need to pick the best option, based on your requirements. And, whether you choose to go with an active or passive mutual fund investment strategy, there are some aspects you must focus on – the peerage of the fund house, the track record of the mutual fund scheme, and the expertise of the fund manager – since you are entrusting your hard-earned money to the scheme you choose. 

Once you have the investment strategy and the scheme in mind, also compare expense ratios to ensure that you are not spending a significant chunk of your investment on expenses, since this amount will not be invested in mutual fund units. Over time, a high expense ratio has the power to curtail your returns, despite the high performance of your scheme, so be conscious of how much you are spending in the quest for market-beating returns. 

In India, the mutual fund industry has proven its prowess as an excellent pooled investment vehicle and its ongoing growth phase is a superb opportunity for investors to join the bandwagon if they have not done so yet. Once you decide on the best investment strategy for yourself, after considering your investor profile, the way forward can be both simple and highly rewarding.