A passively managed fund tries to mimic its benchmark index, while an actively managed fund tries to beat the market.
What are actively managed funds?
With actively managed funds, the fund manager has the flexibility to choose where to invest and alter the composition of portfolio as and when necessary. Actively managed funds constantly seek investments opportunities to try to achieve better-than-average returns.
What are passively managed funds?
Passively managed funds buy into the shares that comprise a specific index. The weightage of each asset in the portfolio is the same as the weightage assigned to it in that index. This style of fund management requires little interference from the fund manager. The performance of such a fund is largely determined by the markets.
Also, it is important to know that all passively managed funds may not be index funds. There are quasi index funds that dedicate a majority of the corpus to the index but not the entire corpus and model based index funds that pick up stocks from various indices. Such funds will not imitate the market completely.
Is there a need for the two styles of management?
Passive investing is built on the premise that the markets are efficient. This implies that the current market price has already factored in all the available information about any particular security, leaving little or no scope to exploit mispricing of securities, since the prices already reflect their true value.
On the other hand, active management is based on the premise that the market is not completely efficient. This in turn gives the managers of such funds scope to do better than the market.
How do actively managed funds approach the market?
The fund managers of such funds typically work with a combination of investments that the manager perceives will beat the market. This stock/security selection is made effective by various actions like tweaking existing investments, timing the purchase and sale of securities, proactively looking out and acquiring potential investments. These funds are constantly monitored.
Is there any advantage in managing funds actively?
The primary advantage of an actively managed fund is that it provides flexibility. Such a fund also has the scope to diversify the investment portfolio which helps in mitigating risk. Active managers seek to build portfolios that try to outperform a fund’s market benchmark.
What can you look out for in actively managed funds?
Actively managed funds frequently move in and out of stocks, so they incur higher trading costs. A lot depends on the skills of the fund manager and the robustness of the processes and systems of investments followed by the fund house. Given the dependence of these funds on the judgment of individual fund managers, monitoring an actively managed fund’s performance becomes imperative.
How do passively managed funds approach the market?
Passively managed funds invest in portfolios that are meant to imitate the market. These funds invest in stocks that comprise an index. The investments may replicate the weightage of the securities as per the index in order to deliver returns that try to match their index. This causes the performance of these funds to mimic the concerned index. They are not designed to perform any better than the market.
What can you look out for in passively managed funds?
There is an element of tracking error in such funds. One must bear in mind corporate actions, liquidity to be maintained and expenditure incurred by the fund. These elements cause a gap to emerge between the fund’s return and the index’s return and this gap is referred to as tracking error.