Understand actively and passively managed funds: There are different investment avenues available in the market for different types of investors. These avenues follow different strategies.
Some are actively managed funds while some are passively managed funds. In this article, we will delve deep into these investing techniques and understand the difference between the two.
Actively and passively managed funds – Understand the difference
In its most basic sense, an actively managed investment fund means a fund in which a manager or a management team of the fund makes decisions about the investment of the scheme’s money. Simply put, in this type of investing strategy, the fund manager is active in making investment decisions and the manager works in a dynamic environment.
More often than not, there is a high probability that you will hear “actively managed fund” in relation to a mutual fund.
What are actively and passively managed funds in the market, passively managed funds simply follow a market index? In this type of investment strategy, the fund manager makes sure that the investment in the asset classes is in the same proportion as in the benchmark index.
Therefore, the performance of passively managed funds tends to replicate the performance of the benchmark index.
To put things into perspective, actively managed funds need a hands-on approach as the fund manager actively decides where to invest the capital. On the contrary, passively managed funds require a hands-off approach as they typically follow a market index.
The primary goal of an active fund manager is to exceed the returns delivered by the market. Therefore, the focus is on getting better returns by selecting investments he/she believes will deliver solid returns.
While there are several ways to measure the performance of the fund, each fund gets measured against the appropriate market index, or benchmark, after giving consideration to the stated investment strategy.
Challenges in actively and passively managed funds
One of the main targets which the active manager needs to achieve apart from offering stronger-than-benchmark returns is to make sure that their funds’ performance should compensate for operating costs.
Returns of actively managed funds are decreased first by the expenses related to the hiring of a professional fund manager, and then by the expenses related to the buying and selling of investment securities in the fund. Let us understand with the help of an example.
Consider an actively managed fund having management and administrative fees of 1.5% of the total assets of the fund. The benchmark of the fund gave a return of 10%. To beat this benchmark return, the portfolio manager will have to deliver a return higher than 11.5% (before the fees). Anything less will mean that the fund has lagged behind the performance of the benchmark index.
Passively managed funds tend to replicate the performance of the benchmark index. An index fund is an example of a passively managed fund. This is because index funds are not required to retain active professional managers since they track the portfolio of the benchmark index.
Even though this strategy tends to benefit in the long run, sometimes the potential for gains and losses is required to be assessed as and when market dynamics change. The need for portfolio reallocation might arise during economic changes. Passive investment managers are deprived of making such changes which can somehow limit the returns.
Advantages of actively and passively managed funds
Low costs are one of the biggest advantages of passively managed funds. Transaction costs (or commissions) are low in the case of passive strategy.
Because their holdings are not as frequently traded as in the case of actively managed funds, they tend to have lower operating costs in comparison to actively managed funds. Still, the fees vary from index fund to index fund. Therefore, the returns on these funds vary.
Another important advantage of passive investing is diversification. Passively managed funds cater to strategies that inherently provide investors with an efficient and inexpensive way to diversify their investments. This is because index funds are able to spread risk by holding a wide array of securities.
Investors having a lower risk appetite tend to prefer passively managed funds as opposed to actively managed funds as passive investing is less risky.
What are actively and passively managed funds to be explained and there are several advantages of actively managed funds too. These funds can beat the index returns.
Since the fund manager works in a dynamic environment, an adequate investment strategy results in capturing greater risk-adjusted returns relative to a benchmark index.
Another advantage of active management strategies is flexibility. The fund managers have an option to buy stocks in different market cycles. They can sell underperforming stocks when they become risky.
They can choose not to invest when risks are too high and they tend to wait for good opportunities to buy.
Market conditions can change on a frequent basis with little or no warning. As investors try to examine where to park capital, it is extremely important to conduct research and compare the benefits and drawbacks of both actively and passively managed funds.
Another important thing that investors need to consider is their risk tolerance and time horizon. While investing provides benefits in the long run, active fund managers tend to capitalize on short-term opportunities too.
However, this can sometimes be quite risky. Risk and reward can vary depending on the investment objective of the fund.
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