In mutual funds there are two subcategories, which are active funds and passive funds.
As the name suggests, these funds are actively managed. The fund manager picks stocks as per his choice, i.e. fund manager has more involvement in the decision making. Actively managed funds generally are considered to be more aggressive and charge high expense ratio, because a lot of effort goes into the research and analysis. The Fund manager, along with analysts and researchers, actively engage in research, buying and selling stocks to achieve best possible returns. Hence, a Fund which is actively managed by a fund manager and his team is known as an active fund.
A passive fund or an Index fund / an Exchange Traded Fund is a type of fund that the fund manager and his team does not actively manage stocks. They need to replicate the index or benchmark. A deviation between actual performance i.e. a position (usually an entire portfolio) and its corresponding benchmark is called as an index funds tracking error. The tracking error may be tied to the expenses related to managing the index fund such as fund’s inflows and outflows. However, they have lower expense ratio as compared to their actively managed counterparts. Also, index funds are a good way for a new investor because you do not need to research.
Difference between Passive Funds & Active Funds
Passive funds are more popular as compared to Active Funds because they have low expense ratio. Involvement of Fund Manager in an Index Fund is lesser.
These funds do not try to beat the benchmarks. Index Funds returns may be equal to the benchmark’s returns or lesser.
In active funds, the fund managers are involved in lot of industry research, based on which they take positions in the markets. Hence compare to passive fund w.r.t. active fund investors will have to pay higher charges (namely expense ratios) for the fund manager’s expertise and decision making.
Actively managed funds seek higher Alpha, which means they take a little more risk to generate those higher returns than the benchmark. Their main objective is to beat the benchmark thus making them riskier. Imagine if fund manager takes a wrong call, it can result into huge losses.
Whether you invest in active or passive fund, the returns will vary as per the market cycles. You can take opportunity of the combined benefits of these funds to give your portfolio the balance of risk and reward.
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