CHAPTER 5: Active Investment Vs. Passive Investment

    Before we jump to the advantages, disadvantages and limitations of Active and Passive investing, let us first understand what it actually means. The core idea of Active-Passive is, it identifies the style of investment strategy. These are two broad categories, that reflects investment style one can follow to build a portfolio. Funds or schemes based on Active Investment strategy are called as Active (actively managed) Funds whereas, Funds or schemes based on Passive Investment strategy are called as Passive funds. 

Passive Investment

        As name suggest, passive investment strategy is a method in which investor deploys money in predefined idea. Investor does not have to micromanage the allocation on daily basis. The investment then mirrors the performance that is given by that particular predefined idea. There are over 1000 listed companies in stock market. It is difficult to track price movement of each and every stock on daily basis. So, the ‘Index, an indicator that reflects the broader movement of market is followed by Investors or Fund managers to gauge the directions and magnitude of market movement. In simple words, Index can be a reference point to understand if the stocks are moving Up or Down and by how much percentage. But one should use it as a reference only and not as a benchmark. Two most observed indices are BSE SENSEX and NIFTY 50. BSE Sensex is the composition of 30 companies from diverse segment of business. Every sector e.g., Banks & financial, consumer goods or IT; has certain weightage in the index and cherrypicked companies representing such sectors gets a position in the index as per assigned weight. Usually, Banks and financial companies carry 33-35% weightage whereas Chemical sector carry 0.55% weightage. Similarly NIFTY 50 Index of National Stock Exchange is a set of 50 companies.

Active Investment

         This style of investment is purely based on active participation of Fund manager. Fund Manager uses his expertise and experience to build and manage the fund very actively and Buy – Sell – Replace – Shuffle stocks or securities in the fund on almost daily basis. Often, fund managers get inputs from highly or equally qualified members from research team. Fund manager and mutual fund companies are under constant pressure to not only beat the predefined benchmark but also to surpass the returns of peers consistently.

Let us look at the broader aspects of Active and Passive Funds. 

Attribute	Passive Funds	Active Funds
Cost	Low Cost, since Fund manager just mirrors the Index	Cost is Slightly higher that Passive Funds. Usually, smaller Active funds charge below 2.10%* per Year that is still as low as 0.0057% per day. Also refer returns Column below, performance is always post expenses.
Bias	No Human intervention so no possibility of Fund managers bias	Since actively managed, fund can be tilted toward particular sector of stock. In fact, thematic fund category is all about bias toward investing in particular sector only. E.g., Infrastructure funds invest only in Infra related stocks, whereas IT/ Digital Funds invests only in IT stocks just to tap the future potential of digital revolution. Same with the Healthcare funds, post covid these funds witnessed decent returns. Hence BIAS aspect should not be considered as negative only.
Effect of Economic Uncertainty	The companies which have secured position in index are not isolated from geopolitical risk and are also exposed to impact of volatility due global/domestic economic factors, Inflation, Interest rate risk, currency risk (IT and export sector) and overall demand supply risk. Bottomline INDEX FUNDS ARE NOT RISK FREE.	Active Funds face exact same set of risks which passive funds are exposed to.
Volatility	Passive funds are exposed to Price volatility. In April 2020 when Sensex & NIFTY 50 (Indices) bottomed out, all the Index funds gave negative returns like Active funds in that time frame.	Active Funds face similar volatility risks which passive funds are exposed to.
Downside Risk / Hedge against Fall	This is one of the major negative points of Index Funds, whenever there is dislocation in price of particular stock or if particular sector is undergoing fundamental changes (e.g., Telecom) and witnessing sudden downfall, investor cannot isolate themselves from the fall of particular stock.	Fund manager, Research team and Investment committee can immediately intervene and can take measures to restrict the downfall of the fund either by reducing the exposure or employ hedge strategy to counterbalance the effect. Sometime fall in price also gives an opportunity to accumulate good businesses at attractive price. In passive investment this cannot be done since Passive is AUTOPILOT strategy.
Diversification	BSE Sensex is contribution of 30 companies and Nifty 50 is a set of 50 companies. Beyond that there is no scope for diversification	Most of the Actively managed schemes hold more than 40 or 50 stocks. This provides good opportunity to diversify the portfolio. Key to reduce the risk is diversification. This aspect is lower in Passive Funds.
Fund Manager Expertise	Passive funds are like machine made or readymade or off the shelf products. No expertise of Fund manager required to run the fund. There is nothing to manage in them except to mirror the index.	Foundation of Actively managed Funds is to use expertise of Fund manager. This style of investment is more like buying Made to Measure or Customized products. Eventually Customization will add extra cost. Which is mentioned in Cost attribute.
Returns / Performance	Index Funds or passive funds does not guarantee returns. They are just a reflection of broader market.	Despite charging fees, actively managed SMALL CAP funds have beaten BSE 250 Small Cap index. SmallCap Category delivered 33.7%, 27.1%, 15.6%, 19% against Benchmark Returns of 27.2%, 21.9%, 12%, 12.3% on 1 - 3 - 5 - 10 Years’ time frame. That’s constantly beating the Small Cap INDEX for past 10 years.
Capital Allocation to Companies	Investors or Fund manager allocate money to stocks which have potential to grow in future at much faster rate compared to their peers. Just for the sake example assume this… no one can challenge the size and market share of HDFC Bank but who knows, stock of ICICI bank might surprise us as far as stock price movement is concerned.	Fund manager has complete discretion to increase or decrease exposure to particular stock but within predefined limits.

 Having considered all above points, it is evident that except cost factor, Active funds make winning case on almost all fronts. Also, in given format which represents the returns of mutual funds is always post expenses. So, no hidden charges or deduction in returns recorded by any mutual fund scheme.

       We must understand that economic factors are dynamic, Markets are dynamic so investors’ portfolios should also be dynamic. This is the prime reason behind hiring fund managers’ expertise to smartly manage portfolio.

 

* Returns as per value research online April 22 issue.  
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