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Understanding The Difference Between Active And Passive Investment

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Understanding The Difference Between Active And Passive Investment
Deepika Asthana - 22 October 2019

Over time, an increasing number of people in India have started realising the potential of equity investments. Mutual funds are a convenient way for retail investors to invest in stocks. A lot of equity funds are available in the market with different investment objectives and fees related to the management of fund. The return expectations and fees for a particular fund depend upon the investment style of the fund. Normally, equity funds adopt one of the following investment approaches.

- Active investment style

- Passive investment style

The returns generated by a fund and the fees you pay to the fund manager are strongly influenced by the investment strategy.

Active Investment Style

An investment strategy that is focused on generating returns over and above benchmark returns, over a period of time.

Passive Investment Style

The main objective of a passive investment strategy is to mimic the benchmark portfolio and generate returns similar to the benchmark.

The following table summarises the features of each type of investment strategy


Features

Active Investment Style

Passive Investment Style

Fees (The expense ratio)

It has higher investment management cost compared to passively managed funds as these funds try to beat the market by generating alpha. This usually requires research to construct the portfolio.

They are very low-cost funds as no extra research work is needed for replicating the benchmark portfolio.

Diversification

Can be little or highly diversified – at the discretion of the fund manager and the scheme mandate.

Highly diversified in line with benchmark portfolio.

Risk vs Return

There is always inherent risk in stock selection. However, the ability to choose compelling stocks can portend the possibility of high returns.

Very low risk as it is highly diversified but will provide returns in line with overall market returns.

Portfolio Churning

Portfolio churning is high with changing macroeconomic conditions and company-specific events.

Very low churning rate as companies in benchmark are assumed to stay for a longer period of time.

Features provided in the above table may help you to understand pros and cons of each investment style. Actively managed funds attempt to generate positive alpha in order to beat the market which increases the cost of management whereas, passively managed funds generate returns similar to the benchmark, albeit with lower costs.

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